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Lecture 4NPV & Other Techniques
Major Topics•The following topics will be discussed in thislecture :–Concepts of Capital Budgeting.–Major investment criteria, including :•Net Present Value•Payback Rule•Average Accounting Return Rule•Internal Rate of Return•Profitability Index–Non-conventional Cash Flows & Mutually ExclusiveProjects–Modified Internal Rate of Return2
Capital Budgeting•It is the process of decision making with respectto investments in fixed assets.•It helps to consider whether we should accept orreject a proposed project.•Projects may originate from :–Within the firm–Other sources3
Capital Budgeting•Within the firm :–Research & Development (R&D)Department of a firm will search for ways ofimproving existing products or finding newprojects.•Other Sources :–Projects may come from the needs to tacklecompetitions, from demand of suppliers, orusually from the pressure from customers.4
Capital Budgeting Decision Criteria•Capital budgeting focuses on free cash flows,which are the benefits generated from acceptinga capital-budgeting proposal.•Based on these free cash flows, we have somecommonly used criteria for determining theacceptability of investment proposals or projects.–Net Present Value (NPV)–Payback Rule–Average Accounting Return (AAR)–Profitability Index–Internal Rate of Return (IRR)5
Capital Budgeting Decision Criteria•Before we discuss the details, pleasenote that when we are evaluating thesedecision criteria, we need to consider anumber of factors :–Adjustments for Time Value of Money.–Adjustments for Risk.–Value Creation for the firm.6
Background Information•Before illustrating different decision criteria,here are the background information of a newproject.•Your required return for projects of similar riskis 12% p.a.7YearCash Flow $Net Income $0-165,000163,12013,620270,8003,300391,08029,100Average Book Value = $72,000
8Net Present Value (NPV)•Recall from previous lecture about NPV, it can bedescribed as the difference between the marketvalue of a project (How to determine ?) and itscost.•It is also a measure of the value created fromundertaking an investment / a project.•To find the NPV of an investment / a project :–The first step is toestimate the expected futurecash flows.–The second step is toestimate the required returnfor projects of this risk level.–The third step is tofind the present value of thecash flows and minus the initial investment.
9NPV Decision Rule•If the NPV is positive, we should accept theproject.•A positive NPV means that the project isexpected to add value to the firm and willtherefore increase the wealth of the ownersbecause the sum of the discounted futurecash flows is greater than the initialinvestment.•Since our goal is to increase owner wealth,NPV is a direct measure of how well thisproject will meet our goal.
Net Present Value (NPV)NPV = PV – Required InvestmentNPVCCrtt=++01()NPVCCrCrCrtt=+++++++01122111()()...()10
Net Present Value (NPV)TerminologyC0, C1…..Ct= Cash Flow at period t