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Chapter 10 - Capital Budgeting Decision Methods Everything...

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270 Capital Budgeting Decision Methods “Everything is worth what its purchaser will pay for it.” —Publilius Syrus Bank of America buys Merrill Lynch On September 15, 2008 Bank of America (BOA) bought Merrill Lynch & Co. (ML) by offering .8595 shares of BOA stock for each share of ML stock. The purchase was valued at $50 billion. The price paid was 1.8 times Merrill’s tangible book value. Did BOA pay too much? Why did the U.S. Treasury have to lend BOA $20 billion to help consummate the merger? Should the U.S. government have let Merrill Lynch go under as it did Lehman Brothers? This acquisition was approved by the boards of directors of both Bank of America and Merrill Lynch and Co. Federal Reserve Chairman Ben Bernanke admitted, however, that if the deal fell through it could trigger a “broader systematic crisis.” Was Bank of America pressured to purchase Merrill Lynch? This was a capital budgeting decision. Merrill Lynch brings a stable of 16,000 financial advisors to the deal. Bank of America expects to increase the amount of money it manages, and the accompanying fees it collects for doing so, as a result of this merger. There will also be additional underwriting fees to be had. Is this a value adding move by Bank of America? This is what capital budgeting is all about. An investment is made and future benefits are expected as a result of this investment. This chapter shows how to evaluate a capital budgeting project. Source : http://newsroom.bankofamerica.com/index.php?s=43&item=8255 http://hispanicbusiness.com/news/news_print.asp?id=158659
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271 © Cara Purdy ( http://www.fotolia.com/p/13851 ) Learning Objectives After reading this chapter, you should be able to: 1. Explain the capital budgeting process. 2. Calculate the payback period, net present value, internal rate of return, and modified internal rate of return for a proposed capital budgeting project. 3. Describe capital rationing and how firms decide which projects to select. 4. Measure the risk of a capital budgeting project. 5. Explain risk-adjusted discount rates. Chapter Overview We now look at the decision methods that analysts use to determine whether to approve a given investment project and how they account for a project’s risk. Investment projects such as DaimlerChrysler’s expansion project can fuel a firm’s success, so effective project selection often determines a firm’s value. The decision methods for choosing acceptable investment projects, then, are some of the most important tools financial managers use. We begin by looking at the capital budgeting process and four capital budgeting decision methods: payback , net present value , internal rate of return, and modified internal rate of return . Then we discuss how to select projects when firms limit their budget for capital projects, a practice called capital rationing. Finally, we look at how firms measure and compensate for the risk of capital budgeting projects.
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