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Capital budgeting
what long-term investments should a firm take on? 1. does the decision rule adjust for the time value of money? 2. does the decision rule adjust for risk?
"net"
indicates we are subtracting something out
NPV (net present value)
gives the difference b/t the cash flows that the project generates & the cost of the project in today's dollars
NPV rule
to accept investments that have positive values and reject ones with negative values
NPV & "r"
-this is also known as the discount rate that is chosen for the analysis will reflect how risky the project is - the higher this is the more risky the project is - the higher this is the lower the NPV is
Pros of NPV (1 of 3)
takes into account TVM (time value of money)
Pros of NPV (2 of 3)
takes into account project risk
Pros of NPV (3 of 3)
ALWAYS leads you to the right decision
Cons of NPV (1 of 3)
cash flows difficult to estimate
Cons of NPV (2 of 3)
r can be difficult to estimate
Cons of NPV (3 of 3)
management may want to use IRR, as it is easier to understand
IRR (Internal rate of return)
- the most important alternative to NPV - often used in conjunction w/ NPV - has a percentage, it is more often intuitive to people - does not always lead to the right decision
IRR decision rule
Accept the project is the ___ is greater than the required return
Pros IRR (1 of 4)
will often lead you to the same decision as NPV
Pros IRR (2 of 4)
takes into account TVM & accounts for project risk
Pros IRR (3 of 4)
"return" is intuitively appealing & a simple way to communicate the value of a project to non-financial managers
Pros IRR (4 of 4)
if it is high enough, you may not need to estimate a required return
Cons IRR (1 of 2)
project can get multiple of these; leading to an incorrect decision
Cons IRR (2 of 2)
if have mutually exclusive projects or unconventional cash flows, can lead to incorrect decisions
Unconventional Cash Flows (IRR)
-when the cash flows change signs more than once, there is more than one IRR - when you have this, use the NPV to evaluate the project.
Mutually Exclusive projects (IRR)
- if you choose one, you can not choose the other - i.e.: you can chose to make the product of buy the product, but not both. - NPV: choose the project w/ higher NPV - IRR: choose project w/ higher IRR
ALL PROJECTS
- looking to create the most value - CASH IS KING!
NPV
directly measures the INCREASE IN VALUE to the firm & is the most reliable project evaluation tool
higher & NPV
As the discount rate increases (indicating a _______ risk level), the ___ decreases
IRR
the ___ is the r that makes the NPV = 0.
unconventional cash flows or mutually exclusive projects
the npv & irr will lead you to do the same decision except when you have ______________ _____________ _______________ & ________________ _______________ projects.
NPV
if the ___ is greater than 0, the IRR is higher than the discount rate used in the ___ calculation
payback period
how long does it take to get the initial cost back (break-even) in a nominal sense?
Payback decision rule
accept if the ________ period is less than some present limit
Pros payback (1 of 2)
easy to understand
pros payback (2 of 2)
adjusts for uncertainty of later cash flows
Cons payback (1 of 3)
ignores the time value of money & project risk
Cons payback (2 of 3)
requires an arbitrary cut off point & ignores cash flows beyond this cutoff date
Cons payback (3 of 3)
biased against long-term projects, such as research and development, & new projects
profitability index
the present value of an investment's future cash flows divided by its initial cost (positive amount)
payback
(the investment - how much had paid back as of __ year) / amount get the next year
P.I.
Pv of cash flows / initial cost
p.i. decision rule
accept and investment if it's ______ _______ is greater than 1
pros pi (1 of 3)
closely related to NPV (takes into account TVM & project risk), generally leading to the right decisions
pros pi (2 of 3)
easy to understand and communicate
pros pi (3 of 3)
may be useful when available investment funds are limited
Cons pi (1 of 1)
may lead to incorrect decisions in comparisons of mutually exclusive investments

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