FIN504_PowerPoint_Slides_09 - FIN 504 Financial Management Lecture 9 Capital-Budgeting Decision Criteria Topics Decision Rules in Capital Budgeting The

FIN504_PowerPoint_Slides_09 - FIN 504 Financial Management...

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FIN 504: Financial Management Lecture 9: Capital-Budgeting Decision Criteria
2 FIN 504: Financial Management Topics Decision Rules in Capital Budgeting The Decision Rules: Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Modified Internal Rate of Return (MIRR) Some Additional Issues
3 FIN 504: Financial Management Decision Rules in Capital Budgeting We need some rule for judging whether a project should be done. The goal (G) is that we should only do projects that increase firm value and this rule should meet the following criteria: C1) The rule should recognize the time value of money. C2) The rule should incorporate all relevant free cash flows.
4 FIN 504: Financial Management Decision Rules in Capital Budgeting We would also like the rule to avoid (if possible): C3) Arbitrary assumptions, C4) The need for data that has great uncertainty, C5) Excessive complexity of calculation, and C6) Technical problems. Unfortunately, we shall need to make some compromises.
The Five Decision Rules
6 FIN 504: Financial Management Data For simplicity, we shall use the following cash flows for many of our examples (r = 10%): 0 1 2 3 4 -1,000 300 200 400 700
7 FIN 504: Financial Management
8 FIN 504: Financial Management Payback Period EXAMPLE: 3 Year Payback Period Calculation 300 + 200 + 400 = 900 < 1,000 Result: $900.00 < $1,000.00 Bad Project 0 1 2 3 4 -1,000 300 200 400 700
9 FIN 504: Financial Management Payback Period Evaluation C1) Fails (no discounting) C2) Fails (not after payback period) C3) Fails (length of payback period) C4) Passes C5) Passes C6) Passes Result: G) Fails
10 FIN 504: Financial Management Discounted Payback Period The discounted payback period rule says to undertake any project for which the present value of the cash flows within the payback period is greater than the required investment.
11 FIN 504: Financial Management Discounted Payback Period EXAMPLE (r = 10%): 3 Year Discounted Payback Period Calculation: Result: $738.54 < $1,000.00 Bad Project 0 1 2 3 4 -1,000 300 200 400 700 ( 29 ( 29 ( 29 2 3 300.00 200.00 400.00 $738.54 $1,000.00 1.1 1.1 1.1 + + = <
12 FIN 504: Financial Management Discounted Payback Period Evaluation C1) Passes C2) Fails (not after payback period) C3) Fails (length of payback period) C4) Passes C5) Passes C6) Passes Result: G) Fails
13 FIN 504: Financial Management
14 FIN 504: Financial Management Net Present Value (NPV) The NPV of a project is: The present value of cash flows from the project minus the investment, (or

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