Week 4_Capital Budgeting 1

Week 4_Capital Budgeting 1 - Week 4 Capital budgeting:...

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Week 4 Capital budgeting: basic techniques 1
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Table of Contents 1. Capital budgeting–An overview 2. Net present value technique (NPV) 3. Internal rate of return (IRR) 3.1 Advantages of IRR 3.2 Difficulties of IRR approach 4. The payback technique 5. Average accounting rate of return (ARR) 6. Which technique is used in practice? 2
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1. Capital budgeting–An overview Capital budgeting Is an Asset side decision making process To choose those investments that maximize returns to investments (shareholders) The aim is to decide on the projects to invest in (or project evaluation) given opportunity cost Opportunity cost represents the next best alternative Key consideration : whether or not the project provides an adequate return to investors 3
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There are three stages in making capital budgeting decisions: Stage 1 forecasting of future cash flows associated with a project Stage 2 use investment evaluation techniques to decide whether a project is acceptable individually and is the best set of alternative projects Stage 3 decide whether to accept or reject projects 4 1. Capital budgeting–An overview
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Investment evaluation techniques Net present value Internal rate of return (IRR) Payback (Average) accounting rate of return (ARR) Based on the discounted cash flow model (DCF) ad hoc methods 5 1. Capital budgeting–An overview
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Table of Contents 1. Capital budgeting–An overview 2. Net present value technique (NPV) 3. Internal rate of return (IRR) 3.1 Advantages of IRR 3.2 Difficulties of IRR approach 4. The payback technique 5. Average accounting rate of return (ARR) 6. Which technique is used in practice? 6
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2. Net present value technique (NPV) 7 0 CF 1 >0 234 1 NPV = PV of CFs NPV technique Involves calculating the present value of all future cash inflows and cash outflows that will result from undertaking a project These positive and negative present values are then netted off against one another to determine the NPV of the project >0, accept <0, reject =0, indifferent CF 2 CF 3 CF 4 CF 0 <0
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To determine the NPV of a project the following equation can be used: where: F t =c a s h flow generated by the project in year t r= t h e opportunity cost of capital (require rate of return for the companay) C 0 =t h e cost of the project (initial cash flow, if any) n=t h e life of the project in years NPV F t 1 r  t t 1 n C 0 (4.1) 2. Net present value technique 8
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NPV F t 1 r  t t 1 n C 0 106 m 1.07 100 m  $1 m 9 0 CF 1 >=$106 1 CF 0 >=-$100m Example 4.1 Apply the NPV rule to a project that costs $100 million and yields $106 million in one year when the opportunity cost of capital is 7%. Since the NPV is negative, it should be rejected. 2. Net present value technique
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Example 4.2 A company is considering whether to outlay $500,000 for a machine that will generate $150,000 p.a. over the next 5 years.
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Week 4_Capital Budgeting 1 - Week 4 Capital budgeting:...

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