Topic 5 - Topic 5 Investment decision rules Learning...

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Ø Learning Objectives: Ø NPV Decision making rules Ø Alternative Decision rules Ø Making decision between projects Ø Evaluating projects with different lives Topic 5 Investment decision rules
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Prescribe book Berk,J. ,Demarzo,P. and Harford,J.,2009, Fundamentals of Corporate Finance , Pearson Education, Chapter 5.
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NPV Decision making rule Topic 2, NPV Rule: When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. The NPV project depends on its appropriate cost of capital, r. § NPV is positive only for the discount rate less than internal rate of return (IRR), which is the discount rate that sets the NPV of the cash flows equal to zero. § Use IRR to measure the sensitivity of cost of capital and decision making.
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Alternative Rules vs. the NPV Rule We can use alternative rules for projection selection. Sometimes other investment rules may give the same answer as NPV rule, but sometimes not. When the rules conflict, always base your decision on the NPV Rule, which is the most accurate and reliable decision rule.
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Alternative Decision Rules Beside NPV rules, there are still some other techniques to make investment decision for single, stand-alone project within firm. § Payback rule § IRR rule
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The Payback Rule The project can be accept if its cash flows pay back its initial investment within a pre- specified period. The rule is based on the notion that an opportunity that pays back its initial investment quickly is a good idea. Step by step to apply the Pay back rule: 1. Calculate the amount of time it takes to pay back the initial investment, called the pay back period. 2. Accept the project if the pay back period is less
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The Payback Rule Example § Fredrick’s Feed and Farm believe that they can build a new, environmentally friendly fertilizer at a substantial cost saving. The fertilizer will require a new plant that can be built immediately at a cost of $81.6mil. Financial manager estimate that the benefits of the new fertilizer will be $28mmil per year, starting at the end of the first year and lasting for four years.
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This note was uploaded on 12/17/2011 for the course B.A 13 taught by Professor Cr during the Spring '11 term at Haverford.

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Topic 5 - Topic 5 Investment decision rules Learning...

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