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5. FIN 301-F09 Lab 5 Capital Budgeting PART I

# 5. FIN 301-F09 Lab 5 Capital Budgeting PART I - CAPITAL...

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CAPITAL BUDGETING Session goals:  Investment Criteria and Capital Investment Decisions

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Project Example Information You are looking at a new project and you  have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 Your required return for assets of this risk  is 12%. 2
NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is  expected to add value to the firm and will  therefore increase the wealth of the  owners. Since our goal is to increase owner wealth,  NPV is a direct measure of how well this  project will meet our goal. 3

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Computing NPV for the Project Using the formulas: NPV = 63,120/(1.12) + 70,800/(1.12) 2  +  91,080/(1.12) 3  – 165,000 = 12,627.42 Do we accept or reject the project? 4 ( 29 TAKE + + - = = 0 1 1 0 NPV RRR CF C NPV T t t t
Payback Period – Decision Rule How long does it take to get the initial cost  back in a nominal sense? Computation Estimate the cash flows Subtract the future cash flows from the initial  cost until the initial investment has been  recovered Decision Rule –  Accept if the payback  period is less than some preset limit 5

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Computing Payback For The Project Assume we will accept the project if it pays  back within two years. Year 1: 165,000 – 63,120 = 101,880 still to  recover Year 2: 101,880 – 70,800 = 31,080 still to  recover Year 3: 31,080 – 91,080 = -60,000  project  pays back our initial investment in year 3 If the preset limit is 3 years, do we  accept or reject the project? 6
Discounted Payback Period – Decision Rule Compute the present value of each cash  flow and then determine how long it takes  to payback on a discounted basis Compare to a specified required payback  period Decision Rule -  Accept the project if it  pays back on a discounted basis within  the specified time 7

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Computing Discounted Payback for the Project Assume we will accept the project if it pays back  on a discounted basis in 2 years. Compute the PV for each cash flow and  determine the payback period using discounted  cash flows Year 1: 165,000 – 63,120/1.12 1  = 108,643 Year 2: 108,643 – 70,800/1.12 2  = 52,202 Year 3: 52,202 – 91,080/1.12 3  = -12,627 project pays  back our initial investment in year 3 Do we accept or reject the project? 8
Average Accounting Return – Decision Rule There are many different definitions for  average accounting return The one used in the book is: Average net income / Average book value Note that the average book value depends on  how the asset is depreciated.

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5. FIN 301-F09 Lab 5 Capital Budgeting PART I - CAPITAL...

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