CAPITAL_BUDGETING.pptVIP

* * * * * * * * * * * * * * * * * Capital Budgeting Capital Budgeting Decisions Long-term decisions - go or no-go decision on a product, service, facility, or activity of the firm. Involve longer time horizons cost larger sums of money require a lot more information to be collected e.g. estimates of the timing and amount of cash flow Models used have a pre-determined accept or reject criterion. Methods Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period 1. Net Present Value (NPV) Discounts all the cash flows from a project back to time 0 using an appropriate discount rate, r: A +NPV implies that the project is adding value to the firm’s bottom line, therefore, the higher the NPV the better. RULE: Accept if NPV0 reject if NPV0 Example 1 The owner of Perfect Images Salon is considering the purchase of a new tanning bed. It costs $10,000 and is likely to bring in after-tax cash inflows of $4000 in the first year, $4,500 in the second year, $10,000 in the third year, and $8,000 in the fourth year. The company’s cost of capital is 10%. Calculate the NPV for the new tanning bed. Example 2 - NPV - choosing between Projects The owner of Perfect Images Salon has a dilemma. She has to decide between purchasing a tanning bed (e.g.1) or a tanning booth. In either case, the cost of capital will be 10%. The relevant annual cash flows are: Year Tanning Booth 0 -12,500 1 4,400 2 4,800 3 11,000 4 9,500 Should she select the tanning bed or booth? 2. Internal Rate of Return (IRR) The IRR is the discount rate which when applied to the cash flows gives a nil (zero) NPV: RULE: Accept if IRR hurdle rate Reject if IRR hurdle rate Hurdle rate = company’s cost of capital (WACC) Note that the IRR is measured as a percent, while the NPV is measured in money terms. IRR Method Find the NPV(a) at one discount rate (a%) Find the NPV(b) at a second discount rate (b%) Interpolate between the