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LE0AFA~1 - Chapter 9 Capital Budgeting NPV and other...

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9-1 Chapter 9 Capital Budgeting: NPV and other criteria
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9-2 Course structure What we’ve done Overview of finance Financial planning Financial math Bond valuation Stock valuation Coming up next Three classes about Capital Budgeting Introduced in the overview in Lecture 1 Uses financial math from lectures 3 and 4
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9-3 1-3 Capital budgeting In class 1, I listed some decisions that a financial manager would make that could be classified as capital budgeting What long-term investments or projects should the business take on? If we introduce a particular new product, will the benefits outweigh the costs? Open new store? Invest in a new computer system? Generally speaking, these are decisions about how to strategically allocate substantial assets. It’s NOT about day-to-day cash management or minor decisions.
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9-4 Capital budgeting example A Canadian firm is deciding whether to expand to the U.S. If they proceed, then they expect to incur costs of $10m. The expected financial benefits of this expansion can be broken down as $2m in years 1 and 2, $4m in years 3 and 4 and $5m in year 5. Financial managers use financial tools to determine whether these expected future cash flows are sufficient given the costs.
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9-5 Chapter Outline In this class we’ll examine 6 tools that help us arrive at an investment decision. 1. Net Present Value (NPV) 2. The Payback Rule 3. The Discounted Payback 4. The Average Accounting Return 5. The Internal Rate of Return (IRR) 6. The Profitability Index NPV is very commonly used and is the best tool. Strengths and weaknesses of each tool will be described.
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9-6 How do we evaluate these financial decision-making tools? Three main criteria will be used to evaluate the strengths and weaknesses of the six financial decision making tools: 1. Does the decision rule adjust for the time value of money? 2. Does the decision rule adjust for risk? 3. Does the decision rule provide information on whether we are creating value for the firm?
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9-7 Net Present Value (NPV) 9.1 The net present value is the present value of all expected future cash benefits minus the costs. Note that the present value of all expected future cash benefits is also called the market value If the NPV > 0, then accept the project. If the NPV < 0, then reject the project. Performing the NPV calculation is simple using tools from financial math The more difficult element is figuring out what expected future cash flows to use (see chapter 10) and how to estimate the required return for projects of this risk level (see chapter 13).
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9-8 NPV Example #1 You are looking at a new project and you have estimated the following cash flows: Costs in year 0: -165,000 Year 1: CF = 63,120 Year 2: CF = 70,800 Year 3: CF = 91,080 Your required return for assets of this risk is 12%.
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