2 Find MV of equity MV of firm MV of debt 3 Value per share MV of equity of

2 find mv of equity mv of firm mv of debt 3 value per

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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)
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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 - Non-conventional 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 non-conventional cash flow => there are more than 1 IRR. Will depend on what is the discount rate we are using!
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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 cross-over point: take 1 project minus the other such that the first CF is negative : in this case, A-B.
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