3DCF_Capital_Budgeting

3DCF_Capital_Budgeting - NPV, IRR, and Capital Budgeting...

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NPV, IRR, and Capital Budgeting Using DCF Method
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Firm Objective Maximize Value Capital Budgeting Decision Invest in projects that add value to the firm Financing Decision Maximize firm  value through optimal capital structure Payout Decision Return excess cash to investors to maximize shareholder wealth
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Capital Budgeting Decision Invest in projects that add value to the firm Value projects using cash flows, reflecting the timing and magnitude of cash flows and all side effects Discount cash flows using a discount rate that reflects the risk of the project and cost of capital
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Our Goal: Firm Value Maximization How do we accomplish this in capital budgeting? Net Present Value Rule Find and accept projects with a positive NPV NPV is “additive” Value of firm is sum of NPVs of all of its (past, present, and future) projects Accepting a project with a positive NPV increases the value of the firm by the NPV
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CFO Decision Tools Profitability Index, 12% Payback, 57% IRR, 76% NPV, 75% Book rate of return, 20% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Survey Data on CFO Use of Investment Evaluation Techniques SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.
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Net Present Value NPV is the sum of the discounted (by opportunity cost of capital) cash flows from a project Net Present Value Rule Accept if NPV > 0 Reject if NPV < 0 Why use the NPV Rule? Accepting positive NPV projects benefits stockholders The value of the firm rises by the NPV of the project The NPV Rule avoids the pitfalls faced by other investment rules
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NPV vs. Book Rate of Return assets book income book return of rate Book = The components reflect tax and accounting figures, not as transparent as market values or cash flows
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NPV vs. Payback The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. The payback rule says only accept projects that “payback” in the desired time frame. This method is flawed, primarily because it ignores later year cash flows and the present value of future cash flows.
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NPV vs. Payback (cont’d) Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less. 0 500 1800 2000 - C 0 1800 500 2000 - B 5000 500 500 2000 - A 10% @ NPV Period Payback C C C C Project 3 2 1 0
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Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less. 50
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3DCF_Capital_Budgeting - NPV, IRR, and Capital Budgeting...

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