BADM 7090 IIIB 2011 - Capital Investment Decisions (Applying the Net Present Value Rule)

BADM 7090 IIIB 2011 - Capital Investment Decisions (Applying the Net Present Value Rule)

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BADM 7090 Financial Management Unit III.B Capital Investment Decisions: Applying the Net Present Value Rule Text material: GSM, Ch. 8 D. Chance

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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIB p. 2 of 14 Questions How do we identify the cash flows to include in an NPV analysis? How does inflation affect the cash flows and the determination of NPV ? How do depreciation and taxes affect the cash flows?
Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIB p. 3 of 14 Identifying Cash Flows The only cash flows that should be considered are those that are incremental: That is, those cash flows that change as a result of the acceptance of the new project. This includes All incidental and side cash costs and revenues Additional working capital What about Opportunity costs sunk costs overhead?

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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIB p. 4 of 14 Identifying Cash Flows (cont.) What about inflation? The correct approach is to incorporate inflation into cash flows as well as the discount rate.
Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIB p. 5 of 14 Identifying Cash Flows (cont.) Example Problem III.B(1) : Suppose you invest \$50 today and have an expected cash flow in time 1 of \$60, not considering inflation. The real cost of capital is 10%. Expected inflation is 5%. What is the NPV? Expected cash flow is adjusted to \$60(1.05) = \$63 The cost of capital is adjusted to (1.10)(1.05) – 1 = 15.5% NPV = \$63/1.155 - \$50 = \$4.55 Alternatively you can discount real cash flows at the real rate: \$60/1.10 - \$50 = \$4.55

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This note was uploaded on 02/28/2012 for the course BADM 7090 taught by Professor Staff during the Fall '08 term at LSU.

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BADM 7090 IIIB 2011 - Capital Investment Decisions (Applying the Net Present Value Rule)

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