Markets may fail for various reasons to deliver
the socially optimal outcome:
Externalities
Imperfect competition
Asymmetric information
Externalities
Public goods
Externalities
Till now we assumed that each consumers
well-being depends only on her own
c
8/3/2016
ECONOMIC PROFIT
The concept of economic profit
Accounting profit
is equal
to total revenue
minus
explicit costs
Economic profit
is equal
to total revenue
minus
all opportunity costs.
Therefore, in economics, if we say that a firm is
earning zero
8/18/2016
Game Theory
Games
Game theory was developed to analyse situations
in which strategic decisions have to be made.
A game is a situation in which a number of
individuals make decisions, and each cares
both about her own choices and about others
cho
8/23/2016
Bertrand Model
Bertrand Model
The simplest possible oligopoly market is
one with two firms (a duopoly) that
produce identical (homogeneous)
goods
There are only two firms in the industry
(so that the industry is a duopoly).
They produce an id
Perfect competition vs. Monopoly
Perfect competition vs. Monopoly
Monopoly is inferior to perfect competition
in two respects.
(1) In perfect competition, the long run
equilibrium is when price is driven down to
the point of the minimum average cost
curv
Pricing Strategies for Monopolist
We have assumed so far that the
monopolist charges the same price to
every buyer
If the monopolist can set different prices
for different customers, it can be shown
that this enables her to increase her profit.
Price Di
Monopoly
Monopoly
A monopoly is the sole producer of a commodity
that has no close substitutes and faces many
buyers.
The existence of the downward-sloping
demand curve sets a constraint on the
monopolists actions
The monopolist can either set the price
8/1/2016
ECONOMIC PROFIT
The concept of economic profit
Accounting profit
is equal
to total revenue
minus
explicit costs
Economic profit
is equal
to total revenue
minus
all opportunity costs.
Therefore, in economics, if we say that a firm is
earning zero
INDIAN MARITIME UNIVERSITY
(A Central University under the Ministry of Shipping)
East Coast Road, Uthandi, Chennai- 600 119
Ph No: (044) 2453 0343/345, Fax: (044) 2453 0342
Website: www.imu.edu.in
Academic Brochure 2014-15
For
Undergraduate & Postgraduate
CHAPTER 10
The Fundamentals of Capital Budgeting
Learning Objectives
1. Discuss why capital budgeting decisions are the most important decisions made by a
firms management.
2. Explain the benefits of using the net present value (NPV) method to analyze cap
B.
We will need to apply the same trial-and-error method to compute the IRR.
When the IRR and NPV Methods Agree
The two methods will always agree when the projects are independent and the
projects cash flows are conventional.
After the initial investment
E. PROFITABILITY INDEX (PI)
The profitability index, or PI, method compares the present value of future cash
inflows with the initial investment on a relative basis. Therefore, the PI is the ratio
of the present value of cash flows (PVCF) to the initial i
Capital budgeting decisions are the most important investment decisions made
by management.
The goal of these decisions is to select capital projects that will increase the
value of the firm.
Capital investments are important because they involve substan
Using NPV
The marketing department of your firm is considering whether to invest in a new
product. The costs associated with introducing this new product and the expected
cash flows over the next four years are listed below. (Assume these cash flows are
1
The Payback Rule
Payback period: The length of time until the accumulated cash flows from the
investment equal or exceed the original cost. We will assume that cash flows are
generated continuously during a period.
The Payback Rule: An investment is accep
Evaluating Equipment with Different Economic Lives
Example (continued)
Like the comparison between an 8% interest rate compounded semi-annually
and an 8.25% interest rate compounded annually, to compare the costs of the
above machines we want to calculate
A. PAYBACK PERIOD
Payback period = Expected number of years
required to recover a projects cost.
2. Ignores cash flows occurring after the
payback period.
B. NET PRESENT VALUE
Year
0
1
2
3
Project L
Expected Net Cash Flow
Project L
Project S
($100)
($100)
Net Present Value (NPV)
The net present value is the difference between the market value of an investment
and its cost.
NPV = - Cost + PV(Future Flows)
T
NPV = - Cost + CF t t
t=1 (1 + r )
T
NPV = CF t t
t=0 (1 + r )
NPV is a measure of the amount of mark
Both cash inflows (CIF) and cash outflows are likely in each year of the
project. Estimate the net cash flow (NCFt) = CIFt COFt for each year of the
project.
Remember to recognize any salvage value from the project in its terminal
year.
3. Determine the
B.
Ongoing and Postaudit Reviews
Management should systematically review the status of all ongoing capital
projects and perform postaudits on all completed capital projects.
In a postaudit review, management compares the actual results of a project with
w
Review of Internal Rate of Return (IRR)
Decision Rule: IRR > Cost of capital Accept the project.
IRR < Cost of capital Reject the project.
Key Advantages
1. Intuitively easy to understand.
2. Based on the discounted cash flow
technique.
Key Disadvantages
F. EQUIVALENT ANNUAL ANNUITY
What do you do when project lives vary significantly? An easy and intuitively
appealing approach is to compare the equivalent annual annuity among all the
projects. The equivalent annuity is the level annual payment across a p
Problems with the IRR Rule (continued)
Mutually Exclusive Projects
Mutually exclusive projects: If taking one project means another project is not
taken, the projects are mutually exclusive. The one with the highest IRR may not
be the one with the highest
Capital Budgeting Problem
Fairways Driving Range
l
Two friends are considering opening an indoor driving range for golfers.
Because of the popularity of golf in Dallas, they estimate that they could rent
20,000 buckets at $3 a bucket in the first year, an
Evaluating Cost Cutting Proposals
Consider the decision to upgrade existing facilities to make them more cost
effective. The financial manager has to determine whether these cost savings are
large enough to justify the necessary capital expenditure.
Con
The Internal Rate of Return (IRR) Rule
Internal rate of return: The discount rate that makes the present value of future
cash flows equal to the initial cost of the investment. Equivalently, the discount
rate that gives a project a zero NPV.
IRR Rule: An
F. EQUIVALENT ANNUAL ANNUITY
What do you do when project lives vary significantly? An easy and intuitively
appealing approach is to compare the equivalent annual annuity among all the
projects. The equivalent annuity is the level annual payment across a p
Note: NPV declines as k increases, and NPV
rises as k decreases.
If the projects are mutually exclusive, accept
Project S since IRRS > IRRL.
C. INTERNAL RATE OF RETURN
Note: IRR is independent of the cost of
capital.
IRR :
CFt
n
= $0 = NPV .
t
t = 0 (1 +
Evaluating Equipment with Different Economic Lives
l
A firm is choosing between two pieces of equipment under the following
circumstances
1.
The pieces of equipment have different economic lives
2.
Whatever piece the firm buys, it needs it indefinitely. A
The Discounted Payback Rule
Discounted Payback period: The length of time until the accumulated discounted
cash flows from the investment equal or exceed the original cost. We will assume
that cash flows are generated continuously during a period.
The Dis