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Intro to Financial Management Capital Budgeting

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Review Homework Cost of bonds –Use net proceeds –Use after-tax cost Cost of common stock –Use net proceeds Cost of retained earnings –Use CAPM

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Capital Budgeting Should a project be accepted or rejected? How should a firm decide which projects to undertake?

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Payback Period Number of years to recover initial cash outlay Example year1year2year3year4year5 Outlay -$10k Cash Flow $2k $4k $3k $3k $9k Payback is 3.33 years Firm may set criteria, such as 3 year payback period –In this case, would reject the project

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Payback Period Positives Deals with cash flows, not profits Easy to calculate Negatives Requires good forecasts Ignores time value of money –Completely ignores money after payback period threshold Payback period may be arbitrary

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Discounted Payback Instead of using simple cash flows – use discounted cash Then calculate the number of years to payback Payback period requirement is still arbitrary

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Net Present Value Method NPV NPV – the net of all future discounted cash flows Includes entire life of project –Later years will be discounted greater Remember to discount using cost of capital (hurdle rate), k Can deal with outlays in future years NPV = PV(benefits) – PV(costs) NPV shows today’s value of a project Decision criteria is simple –If NPV > 0, accept the proposal

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Profitability Index Method (Benefit – Cost Ratio) PI = PV(future cash) / initial outlay Decision criteria is simple –If PI > 1, accept the proposal Similar to NPV –But only uses initial outlay –In basic form does not accommodate future outlays unless factored into future cash flows

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Internal Rate of Return (IRR) Instead of using k for the discount factor, compute the IRR on the calculator –2 nd CLR WORK –CF-5000Enter –↓2000Enter –↓2Enter –↓3000Enter –↓1Enter –IRRCPT 17.50% IRR Decision criteria –Accept of IRR > hurdle rate (cost of capital)

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NPV – IRR Relationship The higher the discount rate, the lower the NPV IRR is discount rate where NPV = 0 Can have situation with multiple solutions to IRR –Get when future flows may be negative –IRR is then meaningless –Use NPV

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Modified IRR (MIRR) 1.Calculate the PV of all cash outflows –Use k for discount rate 2.Calculate the FV of all cash inflows –Use k for discount rate –Result called terminal value, TV 3.Calculate the MIRR Find the discount rate that equates 1 and 2 PV(outflows) = TV(inflows) / (1 + MIRR) n Calculate on calculator using CPT I/Y Accept if MIRR > hurdle rate

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MIRR Example See earlier IRR example –Assume cost of capital = 8% Cash flows look like: -5000200020003000 Compute PV of outflows –Is just -5000 Compute FV of inflows –2000 for 2 years = 2,332.80 –2000 for 1 year = 2,160 –3000 in last year –Total of 7,492.80 Now compute IRR PV = -5000, FV = 7,492.80, N = 3, CPT I/Y = MIRR = 14.43

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Capital Rationing Have limits on capital available for investing –Can not accept all projects Rank by NPV and accept those with the most value to the business –Maximizes shareholder wealth Practical concern May want to consider discounted payback method as a way to evaluate risk –Two project may both have NPV > 0 –Longer payback means more risk in something going wrong

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