a Screening decisions result in alternative projects being grouped into

A screening decisions result in alternative projects

This preview shows page 4 - 9 out of 21 pages.

a. Screening decisions result in alternative projects being grouped into acceptable and nonacceptable categories. 4
Image of page 4
5 2. Preference decisions - relate to selecting from among several competing courses of action. Preference decisions rank alternatives in order of desirability. IV. Capital budgeting decision methods - several capital budgeting decision models exist and are used in practice. A. Discounted cash flow (DCF) methods - there are two primary methods that consider the time value of money; these are the net present value method and the internal rate of return method. 1. Net present value (NPV) method - computes the expected net gain or loss from a project after discounting all expected future cash inflows and outflows to the present point in time using the required rate of return. a. Required rate of return (RRR) aka discount rate, hurdle rate, cost of capital - is the minimum acceptable rate of return on an investment project. b. For simplicity purposes, any future cash flows are assumed to occur at the end of the period in these DCF methods (although they may actually occur evenly during the future periods). 5
Image of page 5
6 c. Decision rule: a project is acceptable in financial terms if its NPV is zero or positive. d. A crucial point in these DCF methods is identifying the cash inflows and outflows. Only relevant or incremental cash flows should be considered. The following should prove useful in identifying these cash flows: 1. Some relevant cash flows are: At the beginning of the project, Purchase price of new machinery Working capital needs Disposal value of existing machinery In future years of the project's life, Disposal value of proposed machine Release of working capital needs Operating costs that differ b/t alternatives Cash savings or revenues that differ b/t alternatives 2. Some irrelevant items include: 6
Image of page 6
7 Book value of existing machine Depreciation on new machine Costs, costs savings, or revenues that do not differ b/t alternatives 2. Internal rate of return (IRR) method computes the true interest yield being earned by an investment project over its useful life. a. The IRR is the discount rate that causes the net present value of the project to be zero. Stated differently, it is the rate of interest at which the present value of the cash inflows equals the present value of the cash outflows. b. Determining the IRR is a process of trial and error. 1. Choose an interest rate and compute the NPV. If NPV is positive (negative), choose a higher (lower) interest rate and recompute NPV. 7
Image of page 7
8 Continue this process until an interest rate is determined that provides a NPV of zero. c. Decision rule: if the IRR equals or exceeds the company's cost of capital (i.e., required rate of return), accept the project. 3. Relationships b/t NPV method and IRR method.
Image of page 8
Image of page 9

You've reached the end of your free preview.

Want to read all 21 pages?

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture