Chap 9 ndash; Capital Budgeting.ppt

Chap 9 – Capital Budgeting Key Sections: Explain Payback period, NPV and IRR Evaluate advantages, disadvantages of each and determine project acceptability Compute payback, NPV and IRR (with projects with irregular cash flows) Understand capital rationing and disparities Budgeting Criteria Capital Budgeting – decision process relative to investing in fixed assets or other long-term investments in a new product or line of business. Focuses on after-tax cash flows resulting from a project. Should it be undertaken? Compare returns relative to costs Criteria: NPV, IRR and payback period Payback Period How many years to recover the initial outlay? Does it meet the minimum period? Main weakness – ignores TVM But we could PV each cash flow to show TVM Problems: period is arbitrary and ignores later cash flows Advantages: understandable, early cash flows more certain Net Present Value NPV’s of inflows less NPV’s of outflows Measures net value in today’s dollars Criteria: If NPV 0.0 accept but If NPV less than zero, reject Rationale: Discount rate used at least equals cost of capital; if you can’t cover costs, you are destroying shareholder value NPV Illustration @ 10%Year CF PVIF PV 1 12,000 .909 10,908 2 13,000 .826 10,738 3 14,000 .751 10,574 4 15,000 .683 10,245 PV of inflows 42,465 Initial out -35,000 1.000 -35,000 NPV + 7,465 More on NPV Depends on accuracy of cash flow projected Advantages: deals with CF and timing; costs and benefits logically compared Disadvantages: need detailed, long-term cash forecasts Theoretically correct – measures project’s impact; authors prefer. Internal Rate of Return What rate of return does the project earn? How does it compare to our cost of capital? Definition: IRR is the discount rate that produces an NPV of zero What rate does the project earn on the IO? (Use calculators, not tables) Criteria: if over the required rate,