FIN 401 Lecture 2: Capital Budgeting Decisions

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azurelouse708

20 Feb 2017

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Net present value: the difference between the value and the cost of a project in present value terms. Decision rule: if the npv is positive, accept the project. A positive npv means that the project is expected to add value to the firm (the goal of financial management) You are looking at a new project and you have estimated the following cash flows: Your required return for assets of this risk is 15%. Formula approach: (cid:2869). (cid:2869)(cid:2873) + (cid:2875)(cid:2873),(cid:2868)(cid:2868)(cid:2868) (cid:2869). (cid:2869)(cid:2873)(cid:3118) + (cid:2869)(cid:2876)(cid:2868),(cid:2868)(cid:2868)(cid:2868) (cid:2869). (cid:2869)(cid:2873)(cid:3119) = npv > 0, accept the project. Tvm cf, i% = 15%, enter the cfs in chronical order in the list. Calculation: estimate the cfs, subtract the future cfs from the initial cost until the initial investment has been recovered. Cfs occur at the end of the year. Decision rule: accept if the payback period is less than some pre-set limit. Balance at year 1 = 200,000 + 50,000 = ,000.

Related Questions

You are evaluating a project based on the following:

Initial Investment: $750,000

Cash Flows: $200,000 per year for 4 years (end of year)

Required Return: 8%

Required Payback: 4 Years

1. Would you accept or reject the project based on the Net Present Value (NPV)?

2. Would you accept or reject the project based on the Payback Period?

3. Would you accept or reject the project based on the Discounted Payback Period?

4. Based on your answers to Questions 1-3, would you accept or reject the project? Why?

bluehare925

Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.

The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments	Cost	Cash Flow 1	Cash Flow 2
Project A	$ 50	$ -	$ 100
Project B	$ 50	$ 50	$ 25

According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.

This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?

bluelizard621

Year/Project A/ProjectB

1$ (43,500.00)$ (43,500.00)

2 $ 21,400.00 $ 6,400.00

3 $ 18,500.00 $ 14,700.00

4 $ 13,800.00 $ 22,800.00

5 $ 7,600.00 $ 25,200.00

1. Using the above cash flows, calculate the following for each project. Assume a 11% required return a. NPV b. Payback Period c. Discounted Payback Period d. IRR e. MIRR (Combination Approach: Use discount rate given and reinvestment rate of 8%) 2. Assuming independent projects, provide an accept/reject decision for each capital budgeting tool a. Assume payback period criteria is 2.5 years b. Assume discounted payback period criteria is 3 years 3. Assuming mutually exclusive projects, which project should be selected? Why?

FIN 401 Lecture 2: Capital Budgeting Decisions

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