Capital budgeting and decision making

The firms 100000 required rate of return is 15 15 npv

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Unformatted text preview: ve years. The firm’s $100,000 required rate of return is 15%. 15% (250,000) 100,000 100,000 100,000 100,000 100,000 0 1 2 3 4 5 Net Present Value Net NPV is just the PV of the annual cash NPV flows minus the initial outflow. flows Using TVM: P/Y = 1 N = 5 P/Y PMT = 100,000 PMT I = 15 PV of cash flows = $335,216 PV $335,216 - Initial outflow: ($250,000) Initial ($250,000) = Net PV $85,216 Net $85,216 Rationale for the NPV method Rationale NPV = PV of inflows – Cost = Net gain in wealth If projects are independent, accept if the If project NPV > 0. project If projects are mutually exclusive, accept If projects with the highest positive NPV, those highest those that add the most value. that Profitability Index Profitability Index n NPV = Σ t=1 FCFt t (1 + k) - IO Profitability Index n NPV = Σ t=1 n PI = Σ t=1 FCFt t (1 + k) - IO FCFt (1 + k) t IO Profitability Index • Decision Rule: • If PI is greater than or equal to 1, accept. • If PI is less than 1, reject. Internal Rate of Return: IRR Internal 0 1 2 3 CF0 Cost CF1 CF2 Inflows CF3 IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. Internal Rate of Return (IRR) Internal IRR: The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on rate its capital budgeting projects. its Internal Rate of Return (IRR) Internal Internal Rate of Return (IRR) Internal n NPV = Σ t=1 FCFt (1 + k) t - IO Internal Rate of Return (IRR) Internal n NPV = Σ t=1 n IRR: Σ t=1 FCFt (1 + k) t FCFt t (1 + IRR) - IO = IO Internal Rate of Return (IRR) Internal n IRR: Σ FCFt t (1 + IRR) = IO t=1 IRR is the rate of return that makes the PV IRR rate of the cash flows equal to the initial outlay. of equal initial This looks very similar to our Yield to This Maturity formula for bonds. In fact, YTM is the IRR of a bond. is How is a project’s IRR similar to a bond’s YTM? YTM? They are the same thing. Think of a bond as a project. The YTM Think on the bond would be the IRR of the “bond” project. “bond” EXAMPLE: Suppose a 10-year bond EXAMPLE: with a 9% annual coupon sells for $1,134.20. $1,134.20. Solve for IRR = YTM = 7.08%, the annual Solve return for this project/bond. return Calculating IRR Calculating Looking again at our problem: The IRR is the discount rate that The makes the PV of the projected cash flows equal to the initial outlay. equal (250,000) 100,000 100,000 100,000 100,000 100,000 0 1 2 3 4 5 IRR IRR Decision Rule: • If IRR is greater than or equal to If the required rate of return (or WACC), accept. WACC) accept • If IRR is less than the required If rate of ret...
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This document was uploaded on 02/03/2014.

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