Capital Budgeting

Capital Budgeting - Chapter 13 Lecture Notes Capital...

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Chapter 13 Lecture Notes Capital Budgeting Decisions CAPITAL BUDGETING—PLANNING INVESTMENTS Screening decisions -Project must meet a minimum requirement to be acceptable -Required rate of return is the minimum rate of return (hurdle rate, cut-off rate, or cost of capital) the project must yield. -The minimum rate of return is used as the discount rate in NPV to determine if the project passes the screening decision. Preference decisions -Best choice of all alternatives The Time Value of Money “A dollar today is worth more than a dollar a year from now.” DISCOUNTED CASH FLOWS—THE NET PRESENT VALUE METHOD (p. 581.) 1. The length of time of the investment. 2. When cash flows occur. 3. Amount of cash flows. 4. The discount rate. Positive NPV return is greater than the discount rate Zero NPV return is equal to the discount rate Negative NPV return is less than the discount rate Emphasis on Cash Flows Typical cash outflows : - Investment required (is the total net cash outflow at the investment inception -- cash paid for initial investment reduced by salvage value of old equipment sold plus any increased need for working capital, see next), -Increased need for working capital (CA – CL), and -Increased operating costs (including repairs and maintenance). Typical cash inflows : -Increased revenue or decreased costs, -Salvage value at the end of the useful life of the asset, and -Working capital released at the end of the investment. NPV method automatically provides for return of the original investment. Chapter 13 Spring 2012 Page 13-1
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Simplifying Assumptions 1. All cash flows occur at the end of a period (except for the original investment which occurs at the beginning). 2. All cash inflows from the investment are immediately reinvested at the discount rate. Choosing a Discount Rate -Cost of capital Format for NPV Using Present Value Factor Tables Time Cash flow PV Factor (@ discount %) Present Value Now ‘0’ (investment, cash outflow) 1.000 ($ investment) n Single cash flow PV$1 @ (n, %) Cash flow x PV factor n Annual cash flow PVA @ (n, %) Cash flow x PVA factor NPV = Summation of PV of (investment) + PV of cash flow Or with the TI BAII+ Financial Calculator Use the manual that came with your Texas Instrument BAII Plus to understand how to use the NPV program. CF key , is used to enter the cash flows. Key CF (to clear old CF, press 2 nd CLR Work) CF 0 is the initial investment, key in (amount)(±), then press (enter), and (↓) down arrow C01 is the first occurring cash flow: amount (enter) (↓) F01 is the number of times the cash flow will occur in a row: amount (enter) (↓) C02 is the second occurring cash flow…follow the steps for C01. Enter all cash flows in order of receipt. If a cash flow is a single cash flow, then the F is 1. Once all cash flows have been entered press the
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Capital Budgeting - Chapter 13 Lecture Notes Capital...

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