Class6_NPVrule_20_Sep_2004(6slides) - Scenario (2)...

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1 1 Investment Decisions, the NPV Rule, and Other Decision Rules Class #6 2 Today’s plan • Discuss investment decisions – today, we are starting a new topic – we are going to think about how financial managers evaluate various projects – we want to know: how do companies decide whether or not to invest in a new technology? • Payback method • Internal rate of return (IRR) • NPV rule – Decision making when resources are limited Scenario (no need to take notes for the next 3 slides) It is the year 2006, you have worked your way up the corporate ladder _____________ works for Fidelity funds as an assistant portfolio manager _____________ works for Ford Motor Co. in the finance department Suppliers of capital (Fidelity) Users of capital (Ford) Financial intermediaries 4 Scenario (2) Ford has finally decided to start building hybrid cars (half electric, half gasoline) after the success of the Honda Insight and Toyota Prius In order to build these cars, Ford needs to build a new assembly line What should ___________(Ford) say to _________ (Fidelity) in order to convince Fidelity to invest in the project? What does __________(Fidelity) ask _________(Ford) before handing over any cash? What does ________(Fidelity) hope Ford is going to do with the cash? 5 Scenario (3) Fidelity hopes that Ford will invest in profitable projects Fidelity hopes that Ford will not build the hybrid car assembly line unless it is projected to be profitable Fidelity hopes that upper management of Ford doesn’t take the money and go to Disney World for the weekend – we do actually worry that companies may waste our money, but we will discuss this in a later class 6 Investment decision rules • We are going to discuss three decision rules • Then we will discuss why the NPV rule is preferred • Ford’s projected cashflows from the hybrid assembly line are shown below (all amounts shown in $ bn): yr2 0.3 yr 20 0.5 yr3 yr4 yr5 yr6 1.2 1.2 1.2 1.2 yr0 2.7 yr1 0.1
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2 7 Investment decision rules (2) • We see Ford invests $2.7bn at time 0 (today) ? – how many years until the profits equal $2.7bn? yr2 0.3 yr 20 0.5 yr3 yr4 yr5 yr6 1.2 1.2 1.2 1.2 yr0 2.7 yr1 0.1 8 Investment decision rules (3) • We see that profits sum to >$2.7bn after 5 years • 5 years is called the “ payback period • After 5 years we have: 0.1 + 0.3 + 0.5 + 1.2 + 1.2 = 3.3 > 2.7 yr2 0.3 yr 20 0.5 yr3 yr4 yr5 yr6 1.2 1.2 1.2 1.2 yr0 2.7 yr1 0.1 9 Payback period rule • The “payback period rule” says managers should accept the project with the shortest payback period. • What’s good about this rule? • What’s not so good about this rule? 10 Payback period rule (2) • The payback period rule can lead to some pretty strange (stupid) decisions. Lets suppose Ford has to choose between 1 of 3 mutually exclusive projects. That is they can invest in one of three technologies (from the book): 1,800 500 500 C1 2 2 3 Pay back Period +50 0 500 -2,000 C -58 0 1,800 -2,000 B +2,624 5,000 500 -2,000 A NPV at 10% C3 C2 C0 Projec t 11 Payback Rule ¾ Basic idea : how long does it take to get the initial cost back in a nominal sense?
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This note was uploaded on 12/06/2011 for the course UGBA 103 taught by Professor Berk during the Fall '07 term at University of California, Berkeley.

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Class6_NPVrule_20_Sep_2004(6slides) - Scenario (2)...

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