Capital Budgeting Techniques (1)

0 c0 c1 1 irr c2 1 irr2 c3 1 irr3 c4 1 irr4 0 5000

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0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3 + C4 / (1 + IRR)4 0 = $5,000 – $2,500 / (1 + IRR) – $2,000 / (1 + IRR)2 – $1,000 / (1 + IRR)3 – $1,000 / (1 +IRR)4 CF0 (5000); CF1 (-2500)(F1); CF2 (-2000) (F1); CF3 (-1000)(F2); CPT IRR= 13.99% 17
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Comparing Criteria (NPV) Board game: NPV = –$300 + $400 / 1.10 + $100 / 1.102 + $100 / 1.103 NPV = $221.41 CF0(-300); CF1 (400)(F1); CF2 (100)(F2); I (10) CPT NPV = $221.41 CD-ROM: NPV = –$1,500 + $1,100 / 1.10 + $800 / 1.102 + $400 / 1.103 CF0(-1500); CF1 (1100)(F1); CF2 (800)(F1); CF3 (400)(F1); I (10) CPT NPV = $ 461.68 18
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Comparing Investment Criteria MUTUALLY EXCLUSIVE projects Board Game: cash flows Year 1 = $400 = $400 Payback period = $300 / $400 = .75 years CD-ROM: Payback period = 1 + ($1,500 – $1,100) / $800 Payback period = 1.50 years Since the board game has the shorter payback period, the company should choose the board game (if payback is the SOLE or dominant criteria). 19
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Comparing Investment Criteria (IRR) 16.c. Board game: 0 = –$300 + $400 / (1 + IRR) + $100 / (1 + IRR)2 + $100 / (1 + IRR)3 CF0 (-300); CF1 (400)(F1); CF2(100)(F2) CPT IRR = 65.61% CD-ROM: 0 = –$1,500 + $1,100 / (1 + IRR) + $800 / (1 + IRR)2 + $400 / (1 + IRR)3 CF0(-1500); CF1 (1100)(F1); CF2 (800)(F1); CF3 (400(F1) CPT IRR = 30.09% 20
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Incremental IRR d. To calculate the incremental IRR, we subtract the smaller project’s cash flows from the larger project’s cash flows. The incremental IRR is the IRR of these incremental cash flows. Incremental CFs are: CD-ROM – Board game –$1,200 $700 $700 $300 CF0 (-1200); CF1 (700)(F2); CF2 (300) CPT IRR = 22.57% The IRR decision rule is flawed because there is a scale problem. This problem is corrected by calculating the IRR of the incremental cash flows, or by evaluating the NPV of each project. Since the incremental IRR, 22.57%, is greater than the required rate of return of 10 percent, choose the CD- ROM project. (Same decision as NPV) 21
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