Net present value approach the net present value

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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 Investment Opportunities Schedule Investment opportunities 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 Capital 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.

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