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Capital Budgeting1 Select investments which increase value of firm Maximize wealth of shareholders Important to firm’s long-term success  Substantial.

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Presentation on theme: "Capital Budgeting1 Select investments which increase value of firm Maximize wealth of shareholders Important to firm’s long-term success  Substantial."— Presentation transcript:

1 Capital Budgeting1 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 Big Picture…

2 Capital Budgeting2 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

3 Capital Budgeting3 Capital Budgeting Decision Criteria Should you sign Shaq O’ Squeal to a four-year contract for $100 million???

4 Capital Budgeting4 Capital Budgeting Decision Criteria Determine cost Estimate incremental cash flows  Increase in revenue  Increase in expenses

5 Capital Budgeting5 Capital Budgeting Decision Criteria Payback period NPV Profitability index IRR

6 Capital Budgeting6 Payback Period How long until we get our money back???

7 Capital Budgeting7 Payback Period ShaqHackMac mil101 mil10 mil mil010 mil mil070 mil mil0510 mil 170 mil101 mil600 mil

8 Capital Budgeting8 Payback Period Payback: length of time to get $$$ back Rule: accept investments that payback before required period

9 Capital Budgeting9 Payback Period Advantages:  Easy to calculate and understand Useful for small investments  Favors investments with quick returns

10 Capital Budgeting10 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

11 Capital Budgeting11 Net Present Value NPV: PV of cash flow – Cost of Investment Rule: accept investments with a positive NPV

12 Capital Budgeting12 Net Present Value

13 Capital Budgeting13 Net Present Value Advantages:  If assumptions correct, increases value of firm  Discounts future cash flows

14 Capital Budgeting14 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 In an efficient market, should projects have huge positive NPVs???

15 Capital Budgeting15 Profitability Index PI: PV Cash Flows / Cost Rule: accept investments with a PI above 1.0

16 Capital Budgeting16 Profitability Index

17 Capital Budgeting17 Profitability Index Advantages:  Comparing alternative investments  Discounts future cash flows Disadvantages:  Favors lower cost investments

18 Capital Budgeting18 Internal Rate of Return IRR: Discount rate where NPV = 0 Rule: accept investments with an IRR above required return

19 Capital Budgeting19 IRR

20 Capital Budgeting20 IRR Advantages:  Most often used criteria in capital budgeting  Not required to select a discount rate  Does discount future cash flows

21 Capital Budgeting21 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

22 Capital Budgeting22 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)


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