lecture_24_project_eval (1)

lecture_24_project_eval (1) - MA826 FINANCE AND FINANCIAL...

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MA826 FINANCE AND FINANCIAL REPORTING 24 - Capital Project Appraisal A capital project involves initial expenditure followed by a stream of revenues and running costs when the project becomes operational. Capital projects need to undergo an initial appraisal. why?
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criteria? Mainly in terms of risk and returns on the project, including: Extent of synergy with other projects the company has undertaken. Satisfying the constraints within and without. Extent of upside potential. Use of financial or management resources in the best way.
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Methods of Evaluation 1. Net present value NPV 2. Internal rate of return IRR but also: 3. Annual capital charge 4. Shareholder value approach 5. Payback period 6. Opportunity cost 7. Nominal returns 8. Strategic fit
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Methods of Evaluating Risky Projects 1. Sensitivity analysis 2. Scenario testing 3. Simulation 4. Probability trees 5. Certainty equivalents
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In evaluating a project, we need to Define the project Evaluate the most likely cash flows. Decide what these cash flows consist of Calculate the financial result Costs Benefits
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Methods of Project Evaluation 1. Net Present Value- NPV C 1, C 2 , …, C n n project's returns The present value of cash flow: C 1 C 2 C n PV = + + … + (1+r) (1+r) 2 (1+r) n GPV If C 0 is the initial capital investment
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NPV is: C 1 C 2 C n NPV = + +…+ - C 0 (1+r) (1+r) 2 (1+r) n NPV is calculated with r = hurdle rate Hurdle rate > = cost of capital The decision rule : Outcome Decision NPV > 0 Accept: hurdle rate is met NPV < 0 Reject NPV = 0 Inconclusive
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Example Year Cash Flow 1/(1+0.1) n PV £ £ 0 -2200 1 -2200 1 770 0.909 700 2 968 0.8264 800 3 1331 0.751 1000 NPV = + 300 NPV calculated @ discount rate of 10% If discount rate =20% , NPV = -115.93
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Profitability Index = PV/C 0 If index > 1 Accept Example: profitability index of the project = 2461/2200 = 1.12 Internal Rate of Return- IRR IRR of a project is the discount rate when NPV=0 Decision rule Outcome Decision IRR > cost of capital Accept IRR < Reject IRR = Inconclusive
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NPV
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lecture_24_project_eval (1) - MA826 FINANCE AND FINANCIAL...

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