07_Oheads

07_Oheads - Lecture Notes 7 Net Present Value and Capital...

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1 Lecture Notes 7 Net Present Value and Capital Budgeting Recipe for financial decision makers within a firm i. Identify the size and timing of all relevant cash flows. ii. Evaluate cash flow riskiness to get the relevant discount rate. iii. Find the NPV of the cash flows. iv. When comparing alternative projects, discount cash flows to the same date. Garbage-In, Garbage-Out • Applying NPV analysis requires judgments about things like: i. expected revenues and their variability, ii. anticipated expenses and their variability, iii. which costs or revenues are marginal to a project, iv. future tax rates and depreciation rules, v. economic lives of plant and equipment and salvage values, vi. and the appropriate discount rate. • The analysis then gives a precise formula for deciding whether
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2 or not we should proceed with the project. • Precision of method is not the same as precision of result . Judging the results of an analysis • NPV is best used as part of an iterative procedure: i. Identify potential positive NPV projects. ii. Estimate the components needed for a formal NPV analysis. iii. Write down your justifications for the assumptions before you do the analysis. iv. Critically examine the results . v. If the results do not accord with your judgement re-examine the assumptions to see if any of them ought to be changed, care- fully reading your prior justifications. • “Normal profits” correspond to zero NPV projects. A high pos- itive NPV implies “super-normal” profits can be earned. • If an analysis reveals super-normal profits, one needs to explain why the opportunity has not been exploited by someone else.
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3 • Explain where the impediments to competition are. Examples could include: i. introducing a new product that may take time to duplicate; ii. introducing new production technologies or management techniques that reduce costs and may take time to duplicate; iii. using existing facilities to produce new products more cheap- ly than competitors (exploiting “economies of scope”); iv. using existing facilities more intensively to expand output at a lower cost than competitors (exploiting “economies of scale”); v. creating or exploiting barriers – through advertising, dealer network etc. – that raise costs of entry to the market; vi. exploiting legal barriers (such as patents and licences, or zon- ing, environmental and safety laws) to limit or prohibit entry; vii. finding new uses for existing resources (such as discovering minerals, or converting an apartment block to a condominium); viii. obtaining a change in property rights that raises the value of existing resources (for example, by getting land re-zoned). • NPV analysis separates assumptions from conclusions, and forc- es you to present your reasoning so it can be reviewed by others.
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4 • The stock market reaction to an investment plan also reveals oth- er people’s valuations of the plan. If this reaction differs substan- tially from the internal analysis, re-examine the numbers.
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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07_Oheads - Lecture Notes 7 Net Present Value and Capital...

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