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UCLA ECON 106F - Econ 106F Chapter 7 final

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Slide 1Chapter OutlineLearning ObjectivesLearning Objectives7.1 NPV and Stand-Alone ProjectsNPV RuleFigure 7.1 NPV of Fredrick’s Fertilizer ProjectAlternative Rules Versus the NPV Rule7.2 The IRR RuleThe Internal Rate of Return Rule (continued)Applying The IRR RuleApplying The IRR Rule (continued)Applying The IRR Rule (continued)Financial Calculator SolutionApplying The IRR Rule (continued)Figure 7.2 NPV of Star’s $1 Million Book DealComparing the Timing of Costs and BenefitsApplying The IRR Rule (continued)Applying The IRR Rule (continued)Applying The IRR Rule (continued)Figure 7.3 NPV of Star’s Book Deal with RoyaltiesApplying The IRR Rule (continued)Applying The IRR Rule (continued)Figure 7.4 NPV of Star’s Final OfferApplying The IRR Rule (continued)Textbook Example 7.1Textbook Example 7.1 (continued)Figure 7.5 NPV Profiles for Example 7.17.3 The Payback RuleTextbook Example 7.2Textbook Example 7.2 (continued)Alternative Example 7.2Alternative Example 7.2The Payback Rule (continued)7.4 Choosing Between ProjectsTextbook Example 7.3Textbook Example 7.3 (continued)Alternative Example 7.3Alternative Example 7.3 (continued)Slide 40Slide 41Slide 42Slide 43The Incremental IRR RuleTextbook Example 7.4Textbook Example 7.4 (continued)Textbook Example 7.4 (continued)Alternative Example 7.4Alternative Example 7.4 (continued)Alternative Example 7.4 (continued)Alternative Example 7.4 (continued)Alternative Example 7.4 (continued)The Incremental IRR Rule (continued)7.5 Project Selection with Resource ConstraintsProfitability IndexTextbook Example 7.5Textbook Example 7.5 (continued)Alternative Example 7.5Alternative Example 7.5 (continued)Alternative Example 7.5 (continued)Shortcomings of the Profitability IndexShortcomings of the Profitability Index (continued)Chapter QuizChapter 7Investment Decision RulesCopyright ©2014 Pearson Education, Inc. All rights reserved.Chapter Outline7.1 NPV and Stand-Alone Projects7.2 The Internal Rate of Return Rule7.3 The Payback Rule7.4 Choosing Between Projects7.5 Project Selection with Resource ConstraintsCopyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives1. Define net present value, payback period, internal rate of return, profitability index, and incremental IRR.2. Describe decision rules for each of the tools in objective 1, for both stand-alone and mutually exclusive projects.3. Given cash flows, compute the NPV, payback period, internal rate of return, and profitability index for a given project, and the incremental IRR for a pair of projects.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives4. Compare each of the capital budgeting tools above, and tell why NPV always gives the correct decision.5. Discuss the reasons IRR can give a flawed decision.6. Describe situations in which the profitability index cannot be used to make a decision.Copyright ©2014 Pearson Education, Inc. All rights reserved.7.1 NPV and Stand-Alone Projects•Consider a take-it-or-leave-it investment decision involving a single, stand-alone project for Fredrick’s Feed and Farm (FFF).–The project costs $250 million and is expected to generate cash flows of $35 million per year, starting at the end of the first year and lasting forever.Copyright ©2014 Pearson Education, Inc. All rights reserved.NPV Rule•The NPV of the project is calculated as:•The NPV is dependent on the discount rate.from eq. 4.7 for a PerpetuityCopyright ©2014 Pearson Education, Inc. All rights reserved.Figure 7.1 NPV of Fredrick’s Fertilizer Project•If FFF’s cost of capital is 10%, the NPV is $100 million and they should undertake the investment.(IRR is determined at NPV = 0)Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Rules Versus the NPV Rule•Sometimes alternative investment rules may give the same answer as the NPV rule, but at other times they may disagree.–When the rules conflict, the NPV decision rule should be followed–Nevertheless, about 25% of companies do not use the NPV Rule when making investment decisions–Because you may encounter these other methods, we will review some nowCopyright ©2014 Pearson Education, Inc. All rights reserved.7.2 The IRR Rule•Internal Rate of Return (IRR) Investment Rule–Take any investment where the IRR exceeds the cost of capital.–Turn down any investment whose IRR is less than the cost of capital.Copyright ©2014 Pearson Education, Inc. All rights reserved.The Internal Rate of Return Rule (continued)•The IRR Investment Rule will give the same answer as the NPV rule in many, but not all, situations.•In general, the IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows.–In Figure 7.1, whenever the cost of capital is below the IRR of 14%, the project has a positive NPV and you should undertake the investment.Copyright ©2014 Pearson Education, Inc. All rights reserved.Applying The IRR Rule•In other cases, the IRR rule may disagree with the NPV rule and thus be incorrect.–Situations where the IRR rule and NPV rule may be in conflict:•Delayed Investments•Nonexistent IRR•Multiple IRRsCopyright ©2014 Pearson Education, Inc. All rights reserved.Applying The IRR Rule (continued)•Delayed Investments–Assume you have just retired as the CEO of a successful company. A major publisher has offered you a book deal.–The publisher will pay you $1 million upfront if you agree to write a book about your experiences.–You estimate that it will take three years to write the book. The time you spend writing will cause you to give up speaking engagements amounting to $500,000 per year.–You estimate your opportunity cost to be 10%.Copyright ©2014 Pearson Education, Inc. All rights reserved.Applying The IRR Rule (continued)•Delayed Investments–Should you accept the deal?•Calculate the IRR–The IRR is greater than the cost of capital. Thus, the IRR rule indicates you should accept the deal, because 23.38% IRR > your 10.0% Opportunity CostCopyright ©2014 Pearson Education, Inc. All rights reserved.Financial Calculator SolutionCopyright ©2014 Pearson Education, Inc. All rights reserved.Applying The IRR Rule (continued)•Delayed Investments–Should you accept the deal?–Here we use the formula for an annuity ….–Thus, because the NPV is negative, the NPV rule indicates you should reject the deal.Copyright ©2014 Pearson Education, Inc. All rights reserved.Figure 7.2


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UCLA ECON 106F - Econ 106F Chapter 7 final

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