S L CF 100 100 CF 1 60 335 N J 2 4 NPV 4132 6190 56 Put Projects on

S l cf 100 100 cf 1 60 335 n j 2 4 npv 4132 6190 56

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S L CF 0 -100 -100 CF 1 60 33.5 N J 2 4 I/YR 10 10 NPV 4.132 6.190
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56 Put Projects on Common Basis Note that Franchise S could be repeated after 2 years to generate additional profits. Use replacement chain to put on common life. Note: equivalent annual annuity analysis is alternative method.
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57 Replacement Chain Approach (000s) Franchise S with Replication NPV = $7.547. 0 1 2 3 4 S: -100 60 -100 60 60 -100 -40 60 60 60 60
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58 Suppose Cost to Repeat S in Two Years Rises to $105,000 NPV S = $3.415 < NPV L = $6.190. Now choose L. 0 1 2 3 4 S: -100 60 60 -105 -45 60 60 10%
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59 Equivalent Annual Annuity Approach (EAA) Convert the PV into a stream of annuity payments with the same PV. S: N=2, I/YR=10, PV=-4.132, FV = 0. Solve for PMT = EAA S = $2.38. L: N=4, I/YR=10, PV=-6.190, FV = 0. Solve for PMT = EAA L = $1.95. S has higher EAA, so it is a better project.
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EAA and Chain Problem Problem 4
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61 Economic Life versus Physical Life Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage value. Should you always operate for the full physical life? See next slide for cash flows.
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62 Economic Life versus Physical Life (Continued) Year CF Salvage Value 0 -$5,000 $5,000 1 2,100 3,100 2 2,000 2,000 3 1,750 0
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63 CFs Under Each Alternative (000s) Years: 0 1 2 3 1. No termination -5 2. 1 2 1.75 2. Terminate 2 years -5 2. 1 4 3. Terminate 1 year -5 5. 2
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64 NPVs under Alternative Lives (Cost of Capital = 10%) NPV(3 years) = -$123. NPV(2 years) = $215. NPV(1 year) = -$273.
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65 Conclusions The project is acceptable only if operated for 2 years. A project’s engineering life does not always equal its economic life.
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Economic Life vs. Physical Life Problem Problem 7.
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67 Choosing the Optimal Capital Budget Finance theory says to accept all positive NPV projects. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: An increasing marginal cost of capital. Capital rationing
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68 Increasing Marginal Cost of Capital Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital. (More...)
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69 If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
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70 Capital Rationing Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. (More...)
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71 Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
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