Ch8 - 1 Chapter 8 Capital Budgeting and Net Present Value...

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1 Chapter 8 Capital Budgeting and Net Present Value Should we build this plant?
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2 Issues in Ch 8 Chapter 8: Capital Budgeting Techniques 8.1 Payback Period Rule 8.2 Average Accounting Return 8.3 Net Present Value 8.4 Internal Rate of Return 8.5 Profitability Index 8.6 Why is the NPV the best? 8.7 The Practice of Capital Budgeting
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3 What is capital budgeting? Capital budgeting: Total process of planning, evaluating, and selecting on capital expenditures for long-lived assets. Usually requires a large amount of capital expenditures. It could be anything that requires lots of money. “In February 2000, Corning, Inc., announced plans to spend $170 million to expand by 50 percent its manufacturing capacity of optical fiber, a crucial component of today’s high-speed communications networks.” To do or not to do? That is the question! Is there any financial method that Corning can use to make this investment decision?
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4 Capital Budgeting: Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine the discount rate, R (To be discussed in Ch 12). 4. Find NPV, IRR and/or others. 5. Accept or reject project based on the results from sep 4.
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5 Example 1 Coca Cola and Procter & Gamble just announced that they will consider a joint venture ( JV ) for new beverage and snack business. The new idea is to form a limited- liability company, with 50-50 ownership, that will develop and market juice-based drinks and snacks. Coca-Cola will invest $2 billions and the investments will be deprecated on a straight-line basis with zero salvage value for four-year investment period. You are a CFO of Coca-Cola and just created a pro forma income statement for this project. Previously, Coca- Cola hired the consulting company to study market research for new beverage and snack business, and paid $300,000 . The tax rate is 30 percent . The similar project with a similar risk level yields 10%. Your job is to evaluate this project. Is this project acceptable?
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6 Coca Cola Pro Forma Income Statement Year 2006 2007 2008 2009 Sales $2,000 $2,000 $2,000 $2,000 Cost of Goods Sold 1,000 1,000 1,000 1,000 Gross Profit 1,000 1,000 1,000 1,000 Operating Expenses 50 50 50 50 Depreciation 500 500 500 500 EBT 450 450 450 450 Taxes (30%) 135 135 135 135 Net Income 315 315 315 315 Coca Cola Example What is a pro forma income statement?
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7 Q1. What is the operating cash flow (OCF)? Remember from Ch2: Operating Cash Flow (OCF) = EBIT + Depreciation expense – Tax = - Why operating cash flow, instead of accounting income?
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8 Q2. Is the consulting fee of $300,000 relevant in capital budgeting decision? What is the sunk cost?
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9 Time Line for the Joint Venture 0 815 1 815 2 815 3 R=10% 815 4 -2,000
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10 Q3. Is this project acceptable? We will use several capital budgeting techniques to evaluate new projects. Payback period Average accounting return (AAR) Discounted cash flow (DCF) approaches Net Present Value (NPV) - most important Internal rate of return (IRR) – most popular Profitability index (PI)
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11 Q3. Is this project acceptable?
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