Chapter7a

# Chapter7a - Chapter 7 Investment Decision Rules Focusing...

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Chapter 7 Investment Decision Rules

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5 Spring 2011 Focusing Question Do you agree that the share price increases of Rare Element Resources is a bubble? Why or why not?
7 Spring 2011 Course Plan Financial Management Foundation and Tools Valuation Short-term Financial Management Risk and Return Long-term Financing Decisions Financial Statement Analysis Capital Budgeting Working Capital Management Cost of Capital Capital Structure Valuation Principle Time Value of Money Bonds and Stocks Investment Decision Rules

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8 Spring 2011 Outline Decision Rules Standalone Projects Mutually Exclusive Projects Projects w/ Resource Constraints NPV vs. IRR Pay Back Profitability Index Differences in Scales Timing of CF Differences in Lives Delayed Investments Multiple IRRs
9 Spring 2011 Learning Objectives 1. Define net present value (NPV), internal rate of return (IRR), Modified IRR (MIRR), and payback period. 2. Given cash flows, compute the NPV, IRR, MIRR, and payback period, for a standalone project. 3. Compare the above capital budgeting tools under different special situations, and explain the drawbacks of alternative decision rules and why NPV always gives the correct decision.

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10 Spring 2011 NPV vs. IRR for Standalone Projects NPV Rule: accept projects with positive NPV Consider a take-it-or-leave-it investment decision involving a single, stand-alone project. The project costs \$250 million and is expected to generate cash flows of \$35 million per year, starting at the end of the first year and lasting forever. The NPV of the project is calculated as: The NPV is dependent on the discount rate. Assume the cost of capital is 10% per year. PV (benefits) of the project = \$350 million 35 NPV 250 = −+ r
11 Spring 2011 Interpreting Positive NPV Recovery of capital If we invest in the project, we will be able to recover the cost of the project: \$250 million Return on capital The project will provide a 10% return to the investors on their invested capital. Value created for investors The NPV of \$100 million is the additional value that is created for the investors

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12 Spring 2011 NPV Profile IRR = 14% when NPV = 0 NPV = \$100 million when discount rate = 10%
13 Spring 2011 Measuring Sensitivity with IRR Alternatively, the NPV = 0 at 14%.

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Chapter7a - Chapter 7 Investment Decision Rules Focusing...

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