Chapter17

Chapter17 - MANAGERIAL ECONOMICS An Analysis of Business...

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1 MANAGERIAL ECONOMICS An Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall
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2 Chapter 17: Investment Decisions and the Cost of Capital Objectives: After studying the chapter, you should understand: 1. the concepts of capital budgeting and cost of capital 2. some simple techniques for the appraisal of investments 3. some financial models used to estimate the cost of capital
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3 Capital and Capital Budgeting Capital : is the stock of assets that will generate a flow of income in the future. Capital budgeting : is the planning process for allocating all expenditures that will have an expected benefit to the firm for more than one year.
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4 Investment Appraisal Firms normally place projects in the following categories: 1. Replacement and maintenance of old or damaged equipment. 2. Investments to upgrade or replace existing equipment 3. Marketing investments to expand product lines or distribution facilities. 4. Investments for complying with government or insurance-company safety or environmental requirements.
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5 Question for Discussion: What are the factors you would consider when making a choice among different investment projects? 1. 2. 3. 4.
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6 Simple Technique for Appraisal of Investment Payback-period criterion : Payback period is the amount of time sufficient to cover the initial cost of an investment But it ignores any returns accrue after the pay-back period; ignores the pattern of returns; ignores the time value (time cost) of money.
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7 Example : Initial investment: $10 million Cash flow: $2 million per year Payback-period? If cash flow : $4 million per year Payback-period?
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8 Discounting On the other hand, the process of discounting or capitalization is to turn a future stream of services or income into its equivalent present value. When an expected future sum is turned into its equivalent present value, we say that it is discounted or capitalized.
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9 The present value of a single future amount In general, present value (PV) refers to the value now of payments to be received in the future (I). The present value of I after n year at r is: PV= I (1+r) n
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Chapter17 - MANAGERIAL ECONOMICS An Analysis of Business...

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