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Big Picture…. Capital Budgeting. Select investments which increase value of firm Maximize wealth of shareholders Important to firm’s long-term success Substantial cost Cash flows over long time period. Steps in evaluating capital assets. Determine cost of asset

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capital budgeting

Big

Picture…

Capital Budgeting
  • Select investments which increase value of firm
  • Maximize wealth of shareholders
  • Important to firm’s long-term success
    • Substantial cost
    • Cash flows over long time period

Capital Budgeting

steps in evaluating capital assets
Steps in evaluating capital assets
  • Determine cost of asset
  • Estimate incremental cash flows
    • Very difficult but…
    • Very important…
  • Determine decision criteria
  • Apply decision criteria
  • Compare actual results to projected

Capital Budgeting

capital budgeting decision criteria
Capital Budgeting Decision Criteria
  • Should you sign Shaq O’ Squeal to a four-year contract for $100 million???

Capital Budgeting

capital budgeting decision criteria1
Capital Budgeting Decision Criteria
  • Determine cost
  • Estimate incremental cash flows
    • Increase in revenue
    • Increase in expenses

Capital Budgeting

capital budgeting decision criteria2
Capital Budgeting Decision Criteria
  • Payback period
  • NPV
  • Profitability index
  • IRR

Capital Budgeting

payback period
Payback Period
  • How long until we get our money back???

Capital Budgeting

payback period1
Payback Period

Capital Budgeting

payback period2
Payback Period
  • Payback: length of time to get $$$ back
  • Rule: accept investments that payback before required period

Capital Budgeting

payback period3
Payback Period
  • Advantages:
    • Easy to calculate and understand
      • Useful for small investments
    • Favors investments with quick returns

Capital Budgeting

payback period4
Payback Period
  • Disadvantages:
    • Future cash flows not discounted
      • Since favors quick returns, not huge problem
    • Ignores cash flows after payback
      • Coal mine: negative cash flows at end
    • Must select cutoff period
      • Three or four years reasonable
      • 20 years, probably not

Capital Budgeting

net present value
Net Present Value
  • NPV: PV of cash flow – Cost of Investment
  • Rule: accept investments with a positive NPV

Capital Budgeting

net present value1
Net Present Value

Capital Budgeting

net present value2
Net Present Value
  • Advantages:
    • If assumptions correct, increases value of firm
    • Discounts future cash flows

Capital Budgeting

net present value3

In an efficient market, should projects have huge positive NPVs???

Net Present Value
  • Disadvantages:
    • Determining proper discount rate
      • Should it be adjusted for riskiness of each project’s cash flows???
      • Set too high, pass up acceptable projects
        • Buyer with lower discount rate will pay highest price
      • Set too low, decrease wealth of firm
    • Ignores relative cost of investments
      • Project A: cost $1 million; NPV $20
      • Project B: cost $50; NPV $19

Capital Budgeting

profitability index
Profitability Index
  • PI: PV Cash Flows / Cost
  • Rule: accept investments with a PI above 1.0

Capital Budgeting

profitability index1
Profitability Index

Capital Budgeting

profitability index2
Profitability Index
  • Advantages:
    • Comparing alternative investments
    • Discounts future cash flows
  • Disadvantages:
    • Favors lower cost investments

Capital Budgeting

internal rate of return
Internal Rate of Return
  • IRR: Discount rate where NPV = 0
  • Rule: accept investments with an IRR above required return

Capital Budgeting

slide19
IRR

Capital Budgeting

slide20
IRR
  • Advantages:
    • Most often used criteria in capital budgeting
    • Not required to select a discount rate
    • Does discount future cash flows

Capital Budgeting

slide21
IRR
  • Disadvantages:
    • Assumes can reinvest cash flows at IRR
      • NPV assumes reinvest at required rate return
      • NPV assumption more logical
    • Favors short-term investments
      • Difficult to achieve high IRR on distant cash flows

Capital Budgeting

calculating irr
Calculating IRR
  • Spend $10,000 today and receive $17,182 in 8 years
  • Spend $10,000 today and receive $1,993 at the end of the next 10 years
  • Spend $10,000 today and receive $2,000 in year 1; $5,000 in year 2 and $8,000 in year 3 (all at end of year)

Capital Budgeting