Lecture 6 - Capital Budgeting

Lecture 6 - Capital Budgeting - Required Reading Chapter 7...

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Finance - I (MGCR 341) – Prof. de Mot a Investment Decision Rules & Capital Budgeting Finance - I (MGCR 341) – Prof. de Mot a 2 Required Reading Chapter 7 , “Fundamentals of Capital Budgeting” from Berk and De Marzo , Corporate Finance. Subsection “The Discounted Free Cash Flow Model” in Section 9.3 from Chapter 9 , “ Valuing Stocks ” from Berk and De Marzo , Corporate Finance ( pages 252-255 in the book ). Chapter 6 , “ Investment Decision Rules ” from Berk and De Marzo , Corporate Finance. (Except Economic Value Added on pages 157-160). Recommended Reading Chapter 2 , “ Introduction to Financial Statement Analysis ” from Berk and De Marzo , Corporate Finance. Finance - I (MGCR 341) – Prof. de Mot a 3 The Net Present Value (NPV) Rule Capital Budgeting: The process of planning a firm’s investment. Q. When should a firm undertake an investment? When it creates value for the owners of the corporation (the shareholders). Q. When does an investment create value? An investment creates value if the project has a positive NPV. Finance - I (MGCR 341) – Prof. de Mot a 4 The Net Present Value (NPV) Rule 01 2 3 4 T i m e FCF 0 FCF 1 FCF 2 FCF 3 FCF 4 … Free Cash Flows Consider an investment that generates the above stream of free cash-flows. The net present value (NPV) of this investment is : where FCF t is the free cash-flow that arrives at date t and r is the cost of capital associated to the project (which is determined by the market return of other projects of similar risk). = + = 0 ) 1 ( t t t r FCF NPV Finance - I (MGCR 341) – Prof. de Mot a 5 The Net Present Value (NPV) Rule For a single project: Undertake if and only if its NPV is positive. For many independent projects: Undertake all positive NPV projects. For mutually exclusive projects: Among the positive NPV projects, choose the one with the highest NPV. When there is a budget constraint : When there is a fixed investment budget that cannot be exceeded, the company should undertake the bundle of investments generating the highest total NPV. Finance - I (MGCR 341) – Prof. de Mot a 6 Q. Why does a positive NPV investment create value? Because a positive NPV investment provides a higher return than what the market offers for investments of similar risk . Q. Is the NPV rule too mechanical? The actual process of discounting is very simple the difficult thing is coming up with the estimated free cash flows and the discount rate in the first place.
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Finance - I (MGCR 341) – Prof. de Mot a 7 Income Statement Revenues (1) Cost of Good Sold (2) Other Costs (3) Depreciation (4) EBIT (5)=(1)-(2)-(3)-(4) Interest Paid (6) Taxable Income (7)=(5)-(6) Taxes (8) Net Income (9)=(7)-(8) Finance - I (MGCR 341) – Prof. de Mot a 8 Net Income: Problems for Finance 1. We are interested in all the cash that a project generates and that the firm is free to distribute to both debt-holders and equity-holders: Revenues (1) COGS (2) Other Costs (3) Depreciation (4) EBIT (5) = (1)-(2)-(3)-(4) EBIT x T C (6) Unlevered Net Income (7) = (5)- (6) Note: Tc is the marginal tax rate for the corporation Finance - I (MGCR 341) – Prof. de Mot a 9 Notice the following:
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This note was uploaded on 12/10/2011 for the course MGCR 341 taught by Professor Trainor during the Winter '08 term at McGill.

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Lecture 6 - Capital Budgeting - Required Reading Chapter 7...

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