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The
The
The
Chapter Outline
8.1
8.2
8.3
8.5
8.6
Capital Budgeting
Analysis
of potential projects
Long-term decisions
Large expenditures
Difficult/impossible to reverse
Determines firms strategic direction
TVM
considered?
Risk-adjusted?
Ability
to rank projects?
Indicates
Mutually
The
Exclusive
NPV =
t=0
CFt
(1 + R)t
NOTE: t=0
NPV =
t=1
CFt
CF
0
t
(1 + R)
NPV
> 0 means:
Project
Will
NPV
Year 0:
CF = -165,000
Year 1:
CF =
63,120
Year 2:
CF =
70,800
Year 3:
CF =
91,080
CFt
NPV
t
(
1
R
)
t 0
= -165000
CF1
63120
CF2
70800
CF3
91080
Display
C00
C01
F01
C02
F02
C03
F03
I
NPV
You Enter
12,627.41
= PV inflows Cost
NPV=0 Projects inflows are exactly
sufficient to repay the invested capital
and provide the required rate of
return
NPV
Rule:
NPV Method
Meets
Considers
all CFs
Considers
TVM
Adjusts
Can
for risk
Directly
related to increase in V F
Dominant
Payback Period
Computation
Subtract the future cash flows from the initial cost until initial
investment is recovered
Year 0:
CF = -165,000
Year 1:
CF =
63,120
Year 2:
CF =
70,800
Year 3:
CF =
91,080
$
$
$
$
CF
(165,000)
63,120
70,800
91,080
Payback =
Payback =
Cum. CFs
$ (165,000)
$ (101,880)
$
(31,080)
$
60,000
year 2 +
+ (31080/91080)
2.34 years
Advantages
Disadvantages
Easy to understand
Intuitively appealing
IRR
Definition:
Decision Rule:
t
t 0 (1 R )
t
t 0 (1 IRR )
n
Calculator
= -165000
CF1
63120
CF2
70800
CF3
91080
= -165000
CF1
63120
CF2
70800
CF3
91080
Display
You Enter
16.13%
IRR - Advantages
Preferred by executives
Intuitively appealing
IRR - Disadvantages
Period
Project A Project B
-500
-400
325
325
325
200
IRR
19.43%
22.17%
NPV
64.05
60.74
The required
return for both
projects is 10%.
Which project
should you accept
and why?
Profitability Index
Profitability Index
Example of Conflict with NPV
Summary
Calculate ALL -- each has value
Method
What it measures
Metric
NPV
$$
Payback
Liquidity
Years
IRR
E(R), risk
PI
If rationed
Ratio
NPV Summary
Net present value =
Difference
Accept
No
if NPV > 0
serious flaws
Preferred
decision criterion
IRR Summary
Internal rate of return =
Discount
cash flows
Mutually exclusive projects
Payback Summary
Payback period =
Length
ratio
investment if PI > 1
Quick Quiz
Year
0
1
2
3
Cash Flow
$-28,700
15,000
13,900
10,300
NPV = $31,805
IRR =
Payback = 1.99
PI = 1.108
Interest rate?