a.Screening decisions result in alternativeprojects being grouped into acceptable andnonacceptable categories.4
52.Preference decisions- relate to selecting fromamong several competing courses of action.Preference decisions rank alternatives in order ofdesirability.IV.Capital budgeting decision methods - several capitalbudgeting decision models exist and are used in practice.A.Discounted cash flow (DCF)methods - there are twoprimary methods that consider the time value of money;these are the net present value method and the internalrate of return method.1.Net present value (NPV)method - computes theexpected net gain or loss from a project afterdiscounting all expected future cash inflows andoutflows to the present point in time using therequired rate of return.a.Required rate of return (RRR)aka discountrate, hurdle rate, cost of capital - is theminimum acceptable rate of return on aninvestment project.b.For simplicity purposes, any future cashflows are assumed to occur at the end of theperiod in these DCF methods (although theymay actually occur evenly during the futureperiods).5
6c.Decision rule: a project is acceptable infinancial terms if its NPV is zero orpositive.d.A crucial point in these DCF methods isidentifying the cash inflows and outflows.Only relevant orincremental cash flowsshould be considered. The following shouldprove useful in identifying these cash flows:1.Some relevant cash flows are:At the beginning of the project,Purchase price of new machineryWorking capital needs DisposalvalueofexistingmachineryIn future years of the project's life,Disposal value of proposed machineRelease of working capital needsOperating costs that differ b/talternativesCash savings or revenues thatdiffer b/t alternatives2.Some irrelevant items include:6
7Book value of existing machineDepreciation on new machineCosts, costs savings, or revenues thatdo not differ b/t alternatives2.Internal rate of return (IRR)method computes thetrue interest yield being earned by an investmentproject over its useful life.a.The IRR is the discount rate that causes thenet present value of the project to be zero.Stated differently, it is the rate ofinterest at which the present value of thecash inflows equals the present value of thecash outflows.b.Determining the IRR is a process of trial anderror.1.Choose an interest rate and compute theNPV.If NPV is positive (negative), choose ahigher (lower) interest rate andrecompute NPV.7
8Continue this process until an interestrate is determined that provides a NPVof zero.c.Decision rule: if the IRR equals or exceedsthe company's cost of capital (i.e., requiredrate of return), accept the project.3.Relationships b/t NPV method and IRR method.