2)
Find MV of equity (MV of firm – MV of debt)
3)
Value per share = MV of equity / # of shares
*preferred over dividend growth model b/c a lot of firms don’t pay dividends.
Lecture 8: Capital Budgeting
Learning objectives:
1)
Compute payback and discounted payback
2)
Compute average accounting return
3)
Compute IRR and Modified IRR
4)
Compute NPV
5)
Understand strength and weaknesses of the various decision criterions
Good decision criteria:
1)
Adjusts for TVM
2)
Adjusts for RISK
3)
Provides information on whether we are creating value for the firm
NPV:
1.
Estimate the expected future cash flows: AMOUNT, TIMING
2.
Estimate required return (use CAPM)
3.
Find the present value of cash flows and subtract initial investment
NPV Rule: Accept project if NPV > 0
PV(inflows)>PV(Outflows) => value of firm increases.
For this course, whenever there is a conflict btw NPV and another decision rule, use NPV
Payback period:
# of years taken to recover initial costs.
1.
Estimate cash flows (do not need to convert into present cost)
2.
Add the future cash flow to the initial cost until initial investment has been
recovered.
Accept if payback period < preset limit (decided arbitrarily)
Discounted payback period:
1.
Estimate cash flows, convert into present cost
2.
Determine how long it takes to payback on a discounted basis
Accept if payback period < preset limit (decided arbitrarily)
*from tutorials: I always forget to divide the “last one” that covers the cost by the
discount rate, despite remembering to divide for the first few.
AAR (Average accounting return):

Average net income/ average book value

Depends on how accet is depreciated

Target cutoff rate

Accept project if AAR > a preset rate
IRR(Internal rate of return)

Definition: IRR is the return that makes the NPV = 0

General IRR rule: Accept project if IRR > Required return (given)
Calculator steps:
Enter cash flows, then <gold, IRR> to solve for IRR.
NPV vs IRR:
Generally gives the same decision except for:

Mutually exclusive projects

Nonconventional cash flows
Independent projects: Cash flows of one are unaffected by acceptance of another
Mutually exclusive: If cash flow of one is affected by acceptance of other (e.g. limited
available funds, can’t invest in both) => e.g. u can’t go to both Harvard or Stanford, can
only choose one of the 2.
When there are nonconventional cash flow => there are more than 1 IRR. Will depend on
what is the discount rate we are using!
At discount rate of 11.8%, indifferent as NPV is exactly the same.
At discount rate > 11.8%, pick B as it has higher NPV.
At discount rate < 11.8%, pick A as it has higher NPV.
Reasons why NPV cross:
1)
Size differences (smaller project is lower NPV when discount rate =0)
2)
Timing differences (Faster payback => More CF in early years => hence less
sensitive to changes in discount rate.)
To compute the crossover point: take 1 project minus the other such that the first CF is
negative : in this case, AB.
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 Spring '11
 tohmunheng
 Net Present Value