Ch 10 Capital budgeting:Decision criteria and real option considerations

The discount rate contemplates the projects risk

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The discount rate contemplates the project’s risk Average risk of firm? Riskier than average? Sources of positive net present value projects Buyers preferences for established brand names Control over the distribution system Patent control Exclusive ownership of natural resources Inability of new firms to acquire factors of production Access to lower cost financial resources Economies of scale Access to superior labor or management talents Internal rate of return IRR Rate of discount that equates the present value of net cash flows of a project to the present value of the net investment (NINV) Highest discount rate to which you have a break even end point (top of bar graph) IRR characteristics Projects with IRR ≥ k are acceptable Considers the time value of money Opportunity costs Unusual cash flow patterns can result in multiple rates of return More than one sign change for CFs present a potential problem Mutually exclusive projects: Use NPV: a small project can have a greater IRR, but this wouldn’t be preferred to a greater NPV
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Ignoring “non-normal” cash flow patterns problem: NPV > 0 → IRRq > k, and NPV < 0 → IRR < k IRR assumes NCF are reinvested at IRR, less conservative assumption than NPV Question: Why would we ever use IRR over NPV? Profitability index PI Ratio of the present value of future net cash flows over the life of the project to the present value of the net investment Comparing projects of different sizes Highest value per dollar invested Gives estimate of market value of a dollar inside of firm NPV = PVNCF - PVNINV PVNCF = PVNINV + NPV PI = (PVNINV + NPV) / PVNINV PI = 1 + (NPV / PVNINV)
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