Class 10&11&12&13 - Part 1

Class 10&11&12&13 - Part 1 -...

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Capital Budgeting NPV & Other Investment Criteria
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Capital Budgeting Ø Capital Budgeting  is the planning process  used to determine whether an  organization's long-term investment  projects are worth pursuing, i.e. whether  they will increase shareholder value Ø So, it’s one of the very important decisions  that managers have to make
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What type of decisions? Ø Should Wal-Mart open a new superstore in  Chapel Hill? Ø Should Apple enter the new Internet-TV  business? Ø Should Starbucks expand to South Africa  and open a store in Cape Town? Ø Should Bank of America upgrade its IT  system? Ø Should P & G introduce the new line of 
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How to decide? Ø What matters (or should matter in theory)  for management is if the investment is  going to create shareholder value or not Ø Capital Budgeting is nothing but a cost- benefit analysis where we compare the  cash outflows with the cash inflows  associated with the investment
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Good Decision Criteria Ø Does the decision rule adjust for the time  value of money? Ø Does the decision rule adjust for risk? § These two will be taken care of by the cost of  capital of the company, the rate at which we’re  going to discount future cash flows Ø Does the decision rule provide information  on whether we are creating value for the  firm?
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Different Investment Criteria Ø Net Present Value (NPV) Ø The Payback Rule Ø The Discounted Payback Ø The Profitability Index (PI) Ø The Internal Rate of Return (IRR)
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Net Present Value (NPV) Ø The difference between the market value of a  project and its cost Ø How much value is created from undertaking an  investment? § The first step is to estimate the expected future cash  flows § The second step is to estimate the required return for  projects of this risk level (take as given for now) § The third step is to find the present value of the cash  flows and subtract the initial investment which will  give us the NPV of the project
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NPV – Decision Rule Ø If the NPV is positive, accept the project Ø A positive NPV means that the project is  expected to add value to the firm and will  therefore increase the wealth of the  owners Ø Since our goal is (or should be in theory)  to increase owner wealth, NPV is a direct  measure of how well this project will meet  our goal
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Class 10&11&12&13 - Part 1 -...

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