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Lecture 3

# Lecture 3 - UGBA 103 Summer 2008 Lecture Slides Set 3...

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UGBA 103 Summer 2008 Lecture Slides Set 3 Capital Budgeting Criteria 1. NPV Rule 2. Alternatives to NPV Rule i. Payback Period ii. Internal Rate of Return iii. Book Rate of Return

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2 Net Present Value (NPV) Rule Net Present Value (NPV) = Σ t PV 0 ( CF t ) for t =0,1,.. n * =Total PV of future CF’s + Initial Investment Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate based on time and risk of CFs 3. Estimate initial costs Acceptance Criteria: Accept if NPV > 0 Ranking § Criteria: Choose project with highest NPV * n stands here for the life of the project § Ranking makes sense only if the projects are mutually exclusive
3 Why Use Net Present Value? Accepting positive NPV projects benefits shareholders ( it replicates their decision-making process ) NPV takes time value of money into account Decisions based on NPV depend on CFs and on their time and risk characteristics, and on nothing else * NPV has additivity property: NPV(A+B) = NPV(A)+NPV(B). This property facilitates analysis in terms of smallest economically viable components. Examples: Outsourcing of payroll, HR, functions etc NPV enables management to exercise its judgment about the risk of CFs in a rational way by using an established paradigm *From a financial perspective, CFs and their time and risk characteristics are the only determinants of value. Everything else is extraneous from a financial perspective

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4 NPV and Cash Transfers Every possible method for evaluating projects impacts the flow of cash about the firm as follows Cash Investment opportunity (real asset) Firm Shareholder Investment opportunities (financial assets) Invest Alternative: pay dividend to shareholders Shareholders invest for themselves The cash that the firm has can be either invested in a project or paid out as dividend
5 Alternatives to NPV Rule Firms have traditionally used a number of different criteria for: Deciding whether to accept a particular project or not Ranking mutually exclusive projects (MEPs) In the following slides, we shall: Describe how these alternative rules are used Compare these with NPV rule, particularly in terms of whether or not they have properties described earlier on slide 3 (time value of money, exclusion of extraneous factors, additivity property, and use of an established paradigm for considering risk)

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