2.Chapter 09&10

2.Chapter 09&10 - Making Capital Investment Decisions...

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Making Capital Investment Decisions
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Chapter Outline Net Present Value The Payback Rule The Internal Rate of Return
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Capital Budgeting The process of planning for purchases of assets whose returns are expected to continue beyond a year Capital Expenditure A cash outlay expected to generate a flow of future cash benefits for more than a year Decisions can be the most complex facing management
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Capital Expenditure Decisions Expand an existing product line Working capital Refunding Leasing Merger and acquisition Enter a new line of business Replacement Advertising campaign Education and training
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Cost of Capital Firm’s overall cost of funds Investor’s required rate of return Provides a basis for evaluating capital investment projects Does the project earn a high enough return?
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How Projects Are Classified Independent Acceptance or rejection has no effect on other projects Mutually Exclusive Acceptance of one automatically rejects the others Contingent Acceptance is dependent upon the selection of another
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Capital Rationing Most companies have a limited amount of dollars available for investment Funds constraint
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Basic Framework for Capital Budgeting Expand output until marginal revenue equals marginal cost Invest in the most profitable projects first Continue accepting projects as long as the rate of return exceeds the marginal cost of capital (MCC)
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Good Decision Criteria We need to ask ourselves the following questions when evaluating decision criteria Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?
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Project Example Information You are looking at a new project and you have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120 Year 2: CF = 70,800 Year 3: CF = 91,080 Your required return for assets of this risk is 12%.
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Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected
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2.Chapter 09&10 - Making Capital Investment Decisions...

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