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Unformatted text preview: e owners’ wealth. Net Present Value Approach
The net present value approach is based on the use of present values to determine
the group of projects that will maximize owners’ wealth. It is implemented by
ranking projects on the basis of IRRs and then evaluating the present value of the
benefits from each potential project to determine the combination of projects CHAPTER 10 Risk and Refinements in Capital Budgeting 449 FIGURE 10.4
schedule (IOS) for Tate
Company projects Budget
Constraint B 20% C E IRR A F 10% D 0 100 200 250 300
230 400 Cost of
IOS 500 Total Investment ($000) with the highest overall present value. This is the same as maximizing net present
value, in which the entire budget is viewed as the total initial investment. Any
portion of the firm’s budget that is not used does not increase the firm’s value. At
best, the unused money can be invested in marketable securities or returned to the
owners in the form of cash dividends. In either case, the wealth of the owners is
not likely to be enhanced.
EXAMPLE The group of projects described in the preceding example is ranked in Table 10.5
on the basis of IRRs. The present value of the cash inflows associated with the projects is also included in the table. Projects B, C, and E, which together require
$230,000, yield a present value of $336,000. However, if projects B, C, and A
were implemented, the total budget of $250,000 would be used, and the present
value of the cash inflows would be $357,000. This is greater than the return
expected from selecting the projects on the basis of the highest IRRs. Implementing TABLE 10.5 Rankings for Tate Company
Projects Project Initial
investment IRR Present value of
inflows at 10% 20% $112,000 B $170,000 C 100,000 16 145,000 E 60,000 15 79,000 A 80,000 12 100,000 F 110,000 11 126,500 D 40,000 8 36,000 Cutoff point
(IRR 10%) 450 PART 3 Long-Term Investment Decisions B, C, and A is preferable, because they maximize the present value for the given
budget. The firm’s objective is to u...
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This document was uploaded on 01/19/2014.
- Fall '13