FINC-220 Lecture Notes - Lecture 8: Capital Budgeting, Net Present Value, Payback Period

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8 May 2018

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Chapter 9- Net present value and other investment criteria

Chapter outline

• Capital budgeting process

• Net present value

• Payback

• Discounted payback

• The internal rate of return

• Profitability index

• The practice of capital budgeting

Uses of capital budgeting

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Maintenance or obsolescence

Current product or current service

Cost reduction

New product or new service

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Comparison valuations

Net present value

• Definition: The difference between the present value of the future cash flows (i. e. market

value) of a project and its cost

• Computation:

o Estimate the future cash flows

o Estimate the required return for projects of this risk level.

o Find the present value of the cash flows and subtract the initial investment.

NPV- decision rule

• A positive NPV means that the project is expected to add value to the firm and will

therefore increase the wealth of the owners.

• Since our goal is to increase owner wealth, NPV is a direct measure of how well this

project will meet our goal, as measured in dollar terms.

o If the NPV is positive (NPV > $0), then we ACCEPT the project.

o Conversely, if the NPV is negative, then we REJECT the project.

Project example information

 You are reviewing a new project and have estimated the following cash flows:

 Year 0: CF = -165,000

 Year 1: CF = 63,120

 Year 2: CF = 70,800

 Year 3: CF = 91,080

 Your required return for assets of this risk level is 12%.

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Net present value computation

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Document Summary

Chapter 9- net present value and other investment criteria. Chapter outline: capital budgeting process, net present value, payback, discounted payback, the internal rate of return, profitability index, the practice of capital budgeting. Payback decision: we need to know a management"s number. Required rate of return is 15% and cutoff payback is 2 years. Discounted payback: advantages, includes time value of money, easy to understand, biased towards liquidity, disadvantages, requires an arbitrary cutoff point, ignores cash flows beyond the cutoff point, biased against long-term projects, such as r&d and new products. Internal rate of return: this is the most important alternative to npv, definition: it is the discount rate (or required return) that will bring all of the cash flows. It is often used in practice and is intuitively appealing into present value time and total the exact value of the cost of the project: said another way, it is the return that will yield a npv =sh.

Related Questions

You are a financial analyst for the Waffle Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects A and B. Each project has a cost of $50,000, and the cost of capital for each is 10%.

The projects’ expected net cash flows are as follows:

	Expected Net Cash Flows
Year	Project A	Project B
0	($50,000)	($50,000)
1	25,000	15,000
2	20,000	15,000
3	10,000	15,000
4	5,000	15,000
5	5,000	15,000

Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI).

peachturtle69

Which of the following statements are true? Select 4 that apply. (4 points)

Discounted payback method of capital appraisal ignores cash flows beyond the discounted payback period.

The net present value is found by discounting all positive cash flows at the projectâs cost of capital.

The project is accepted if the IRR is less than the projectâs cost of capital.

The IRR is the discount rate which forces the present value of a projectâs future cash flows to equal the future value of its costs.

Firms often choose among mutually exclusive projects on the basis of the present value of future costs.

To use the CAPM approach in capital budgeting, we estimate the firmâs beta, multiply this by the market risk premium and add the firmâs risk premium to the risk-free rate to obtain the firmâs cost of retained earnings or cost of equity.

The best proxy for the risk-free rate is the yield on treasury bonds.

Floatation costs are generally material when looking at its effect on the after-tax cost of debt.

burgundygnat457

You are a financial analyst for the Axum electronics company. The director of capital budgeting has asked you to analyze the proposed capital investment for project x. the project has a cost of $90000 and the cost of capital (ko) of the project is 12%. The project's expected life of the project is 5 years and the salvage value is zero. The project's expected net cash flows are as follows: Year 1 = 30000; year 2 = 30000; year 3 = 30000; year 4 = 30000; year 5 = 30000.

Calculate the project's payback period.

Calculate the project's net present value (NPV).

Determine the internal rate of return (IRR) of the project.

Should the project be accepted or not?

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FINC-220 Lecture Notes - Lecture 8: Capital Budgeting, Net Present Value, Payback Period

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