05 Fin 301 Capital budgeting - NPV alternatives Ulearn

05 Fin 301 Capital budgeting - NPV alternatives Ulearn -...

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1 Alternative Investment Criteria What Should a Good Criterion Do? ± A good evaluation method should ± Consider all cash flows ± Account for timing differences ± Provide unambiguous decision rule 2 ± Measure wealth created for shareholders ± Some criteria that don’t ± Payback ± Discounted Payback ± Average Accounting Return Net Present Value 0 1 T t t CF NPV I RRR =− + All cash flows 3 ( ) 1 0T A K E t NPV = + ≥⇒ Clear Decision Timing Differences
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2 NPV Example ± XYZ Corp. considering an expansion project requiring an immediate outlay of $110,000 ± Project would increase cash flows by 4 $14,000 per year for 10 years (starting next year) ± Residual salvage value: $100,000 ± Should XYZ take project if RRR = 10%? NPV Example 123 1 0 $14,000 $14,000 $100,000 $14,000 $14,000 – $110,000 0 5 () 578 , 14 $ 1 . 0 1 1 000 , 100 $ 1 . 0 1 1 1 1 . 0 1 000 , 14 $ 000 , 110 $ 10 10 = + + + + = NPV ± Take project if PI > 1 . Why? 0 I PV PI = Profitability Index (Benefit/Cost Ratio) 6 0 0 1 0 0 0 > > > > NPV I PV I PV I PV
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3 PI Example ± Project A costs $200 and has a PV of $220 ± Project B costs $100 and has a PV of $110 ± Calculate PI A and PI B ! Which should we take?
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05 Fin 301 Capital budgeting - NPV alternatives Ulearn -...

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