09-Capital-budgeting-FIN6406 - Capital Budgeting n Payback...

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Capital Budgeting  Capital Budgeting 11 Capital Budgeting n Payback period n Net present value (NPV) n Internal rate of return (IRR) n Profitability index (PI) n Modified IRR (MIRR)
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Capital Budgeting  Capital Budgeting 22 What Is capital budgeting? n Analysis of potential additions to fixed assets . n Long-term decisions n Involves large expenditures n Very important to firm’s future and growth.
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Capital Budgeting  Capital Budgeting 33 Generic Steps 1. Generate ideas for new projects. 2. Estimate CFs (inflows & outflows). 3. Assess riskiness of CFs. 4. Determine risk-adjusted discount rate R = WACC (adj.). 5. Find NPV and/or MIRR. 6. Accept if NPV > 0 and/or MIRR > WACC.
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Capital Budgeting  Capital Budgeting 44 Mutually Exclusive Projects (Versus Independent Projects) BRIDGE VS. BOAT TO GET PRODUCTS ACROSS A RIVER
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Capital Budgeting  Capital Budgeting 55 Normal Project Cost (negative CF) followed by a series of positive cash inflows. Non-normal Project One or more outflows occur after inflows have begun. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Examples: Nuclear power plant, strip mine.
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Capital Budgeting  Capital Budgeting 66 Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N N N - + + + + + N - + + + + - N N - - - + + + N Examples of Normal & Non-Normal Project CFs
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Capital Budgeting  Capital Budgeting 77 Cash Flows for Project L and Project S 10 80 60 0 1 2 3 -100 Project S: -100 Project L: Note : Project L has larger inflows later, and Project S has larger inflows earlier in the life of the project. Years: 70 50 20
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Capital Budgeting  Capital Budgeting 88 What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get our money back?
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Capital Budgeting  Capital Budgeting 99 Payback for Project L (Long: Most CFs in out years) 10 80 60 0 1 2 3 -100 CF t Cumul -100 -90 -30 50 PaybackL = 2 + 30/80 = 2.375 years. 0
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