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Lecture 19 - Capital Budgeting - NPV and Other Criteria (II)

Lecture 19 - Capital Budgeting - NPV and Other Criteria...

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Today Capital Budgeting: NPV and Other Criteria (Chapter 9) BAFI 355 – Spring 2010 19-1
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Capital Budgeting: Decision Rules The methods Net present value (NPV) Payback Discounted payback Internal rate of return (IRR) Profitability Index (PI) BAFI 355 – Spring 2010 19-2
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The Internal Rate of Return (IRR) Rule IRR The discount rate that equates the present value of a project’s The discount rate that equates the present value of a projects expected inflows to the present value of project’s costs Solving for IRR 1 2 3 0 CF 0 CF 1 CF 2 CF 3 Find IRR such that: 0 1 0 = + = t t t ) IRR ( CF BAFI 355 – Spring 2010 19-3
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Applications: Example 3 Compute the IRR for Project S. Project S: -1,000 500 400 300 100 One needs to solve: 1 2 3 0 4 0 ) IRR 1 ( 100 ) IRR 1 ( 300 ) IRR 1 ( 400 ) IRR 1 ( 500 000 , 1 4 3 2 = + + + + + + + + No closed-form solution. By using either trial-and-error or a financial calculator or Excel you get: BAFI 355 – Spring 2010 19-4 IRR=14.49%
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The NPV Profile NPV profile is the graph relating the NPV of the project to the discount rate. For project S we derive: $300.00 $400.00 Discount Rate NPV 0.0 $300.00 2.5 $237.71 NPV ($100 00) $0.00 $100.00 $200.00 0 5 10 15 20 25 5.0 $180.42 7.5 $127.62 10.0 $78.82 12.5 $33.62 15.0 ($8.33) 17 5 ($47 35) IRR Discount rate ($300.00) ($200.00) ($100.00) 17.5 ($47.35) 20.0 ($83.72) 22.5 ($117.68) 25.0 ($149.44) If we graph the NPV profile, we can see the IRR as the x-axis intercept BAFI 355 – Spring 2010 19-5
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The IRR Rule: Details Rationale for the IRR rule IRR is the project’s expected rate of return. If IRR exceeds cost of f d d fi h j l ill i funds used to finance the project, some surplus will remain On the decision: Minimum acceptance criteria: Accept project if IRR is greater than th i d t th t i t th th h dl t the required return, that is, greater than the hurdle rate Ranking criteria: Select project with highest IRR Strengths Easy to understand and communicate It takes into consideration the time value of money It takes into consideration ALL cash flows
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