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Using Net Present Value to Make Investment Decisions

Explore internal rate of return, alternative investment decision rules, and additional considerations in capital budgeting methods. Survey results reveal popular techniques, including NPV and IRR. Learn how to discount cash flows, estimate incremental payoffs, and incorporate real options. Understand IM&C's Fertilizer Project and determinants of discount rate. Prepare for the next class on risk and return with guest speaker from Merrill Lynch Investment Banking.

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Using Net Present Value to Make Investment Decisions

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  1. Using Net Present Value to Make Investment Decisions • Student Presentations • Net Present Value • Internal Rate of Return • Alternative Investment Decision Rules • Additional Considerations

  2. Capital Budgeting Methods • CFO Survey by Graham and Harvey in 1999 – Which techniques do you always or almost always use? • IRR (76%) • NPV (75%) • Hurdle rate (57%) • Payback (57%) • Sensitivity analysis (52%) • Earnings multiple (39%) • Discounted payback period (29%) • Incorporate “real options” (27%) • Accounting rate of return (20%) • Value-at-Risk (14%) • Profitability index (12%) • Adjusted present value (11%)

  3. What to Discount • Only cash flow is relevant • Estimate cash flows on an incremental basis • Average vs. incremental payoffs • Incidental effects • Include working capital requirements • Include opportunity costs • Forget sunk costs • Beware of allocated overhead costs • Treat inflation consistently

  4. IM&C’s Fertilizer Project

  5. IM&C’s Fertilizer Project (2)

  6. IM&C’s Fertilizer Project (3)

  7. IM&C’s Fertilizer Project (4)

  8. What Discount Rate • Determining the cost of capital is critical • Consider yield curve • Interest rates depend on timing of cash flows • All investments do not have the same cost of capital

  9. Next Class • Risk and Return • Student presentations • Capital Asset Pricing Model • Guest speaker – Brian Callaci, Merrill Lynch Investment Banking • Read Chapters 7 and 8 in the text

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