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Unformatted text preview: Chapter 7 Investment Decision Rules 2 Spring 2010 Focusing Question What is the NPV of an acquisition, and why will the negative NPV of an acquisition lead to a lower stock price of Whole Foods Market, Inc.? 3 Spring 2010 Course Plan Financial Management Foundation and Tools Valuation Shortterm Financial Management Risk and Return Longterm 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 4 Spring 2010 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 5 Spring 2010 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. 6 Spring 2010 NPV vs. IRR for Standalone Projects ¡ NPV Rule: accept projects with positive NPV ¡ Consider a takeitorleaveit investment decision involving a single, standalone 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. 35 NPV 250 = − + r 7 Spring 2010 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 pay to the investors a 10% annual return on their invested capital of $250,000 forever. ¡ Value created for investors ¢ The remaining $100 million is additional value that is created for the investors 8 Spring 2010 NPV Profile IRR = 14% when NPV = 0 NPV = $100 million when discount rate = 10% 9 Spring 2010 Measuring Sensitivity with IRR ¡ Alternatively, the NPV = 0 at 14%. Alternatively, the NPV = 0 at 14%....
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 Spring '11
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 Valuation

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