FIN Ch. 10 Capital Budgeting Technique

Present value of cash inflows less Initial investment

The formula for NPV

Do NPV and IRR always agree with respect to accept/reject decisions?

YESS!!

Net present value (NPV)

is a sophisticated capital budgeting technique; found by subtracting a project's initial investment from the present value of its cash inflows discounted at an appropriate rate of interest.

capital expenditure

is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.

The profitability index (PI)

is equal to the present value of cash inflows divided by the initial cash outflow.

A ranking approach

is not always necessary. A ranking approach is the ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return.

payback method

is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

Internal Rate of Return (IRR)

is the discount rate that equates the NPV of an investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows.

An accept-reject approach

is the evaluation of capital expenditure proposals to determine whether they meet the firm's minimum acceptance criterion.

Capital rationing

is the financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for these dollars.

Unlimited funds

is the financial situation in which a firm is able to accept all independent projects that provide an acceptable return.

Capital budgeting

is the process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owner wealth.

If projects are mutually exclusive

management should choose based on the higher NPV.

If the IRR is < the cost of capital,

reject the project.

If the NPV < $0,

reject the project.

If the payback period is greater than the maximum acceptable payback period

reject the project.

The IRR approach (and the PI method) may favor

small projects with high returns

The NPV approach favors the investment that makes

the investor the most money

According to Profitability index, Invest in the project

when the index is greater than 1.0

there is no guarantee that NPV and IRR

will rank projects in the same order.

IRR is the rate that makes

PV of future cash flows = 0

What is the financial manager's goal in selecting investment projects for the firm?

, maximize shareholder value

Payback Period: Pros and Cons of Payback Analysis

-It does not apply time value of money, -does not consider risk, - does not maximize shareholder value. -In addition, payback ignores cash flows after payback is achieved. -If there are two projects with the same payback period, the technique does not have a way to distinguish one from the other for making a selection.

NPV is the better approach because:

-NPV measures how much wealth a project creates (or destroys if the NPV is negative) for shareholders. -Multiple IRRs - If a project has unconventional cash flows, that is that some future cash flows are negative, then there can be more than one IRR for that project. -NPV uses cash flows -NPV uses Time value of money -NPV considers risk -NPV maximizes shareholder value

Fours Characteristics of a desirable Capital Budgeting Technique:

1. Use cash flows 2. Consider risk 3. Apply time value of money since cash flows are spread across time 4. Maximize shareholder value

Does the assumption concerning the reinvestment of intermediate cash inflow tend to favor NPV or IRR?

It tends to favor the IRR.

If the IRR is ≥ the cost of capital

accept the project.

If the NPV is ≥ $0,

accept the project.

If the payback period is less than the maximum acceptable payback period

accept the project.

Mutually exclusive projects

are projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Independent projects

are projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration.

The IRR technique assumes cash flows are reinvested

at the Internal rate of return

The NPV technique assumes

cash flows are reinvested at the cost of capital.

intermediate cash inflows

cash inflows received prior to the termination of the project.