350-10a_note

350-10a_note - 350-10a_note, 11S TOPIC 10: BASICS OF...

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350-10a_note, 11S Page 1 of 15 TOPIC 10: BASICS OF CAPITAL BUDGETING (CHAPTER 11) I. Outline A. What is Capital Budgeting B. Steps to Capital Budgeting 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine the appropriate cost of capital. 4. Evaluate the project: 5. Make decision to either accept or reject the project C. Evaluation Method 1. Payback period method 2. Discounted payback period method 3. Net present value (NPV) 4. Internal Rate of Return (IRR) 5. Modified Internal Rate of Return (MIRR) D. Adjust for Risk II. Homework Assignment Chapter 11 Question 2, 3, 5, 6, 9 Problem 1-5, 7, 11-13 III. Decision Table Project L Project S Benchmark Decision: Independent projects Decision: Mutually Exclusive projects Payback Discounted Payback NPV IRR MIRR Should we build this plant?
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350-10a_note, 11S Page 2 of 15 Class Notes I. What is Capital Budgeting (Case A, B)? A. Analysis of potential additions to fixed assets. 1. Long-term decisions; involve large expenditures. 2. Very important to firm’s future. B. Independent vs. mutually exclusive projects 1. Independent projects – if the cash flows of one are unaffected by the acceptance of the other. 2. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other. 3. Example: a) If Project L and S are independent b) If Project L and S are mutually exclusive C. Normal vs. Nonnormal cash flow streams 1. Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. 2. Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc. 3. Example: a) Project A: b) Project B: c) Project X: d) Project W: II. Steps to capital budgeting A. Estimate CFs (inflows & outflows). B. Assess riskiness of CFs. C. Determine the appropriate cost of capital. D. Evaluate the project: 1. Payback period method 2. Discounted payback period method 3. Net present value (NPV) 4. Internal Rate of Return (IRR) 5. Modified Internal Rate of Return (MIRR) E. Make decision to either accept or reject the project
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350-10a_note, 11S Page 3 of 15 III. Evaluation: Payback Period Method (Case H) A. What is the Payback Period Method? 1. The number of years required to recover a project’s cost, or “How long does it take to get our money back?” 2. Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. B. Example: Project L Payback L = 2 + / = 2.375 years CF t -100 10 60 Cumulative -100 -90 50 01 2 3 = 30 80 80 -30 Project L’s Payback Calculation Payback L = 2.375 years Payback S = 1.600 years C. Example: Project S D. Making Decision Benchmark? E. Strengths and weaknesses of the Payback Period Method? 1. Strengths a) Provides an indication of a project’s risk and liquidity.
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This note was uploaded on 09/30/2011 for the course FIN 350 taught by Professor Chen during the Spring '07 term at S.F. State.

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350-10a_note - 350-10a_note, 11S TOPIC 10: BASICS OF...

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