Capital budgeting ppt@ bec doms on finance

1. Capital Budgeting

8. Capital Budgeting Techniques—Payback Example 10.1 8 Q: Use the payback period technique to choose between mutually exclusive projects A and B. Example 800 200 C 5 800 200 C 4 350 400 C 3 400 400 C 2 400 400 C 1 ($1,200) ($1,200) C 0 Project B Project A A: Project A’s payback is 3 years as its initial outlay is fully recovered in that time. Project B doesn’t fully recover until sometime in the 4 th year. Thus, according to the payback method, Project A is better than B. But project B is clearly better because of the large inflows in the last two years

13. Capital Budgeting Techniques Net Present Value (NPV) Example 10.2 13 Q: Project Alpha has the following cash flows. If the firm considering Alpha has a cost of capital of 12%, should the project be undertaken? Example $3,000 C 3 $2,000 C 2 $1,000 C 1 ($5,000) C 0 A: The NPV is found by summing the present value of the cash flows when discounted at the firm’s cost of capital.

18. Internal Rate of Return (IRR) Example 10.4 18 Q: Find the IRR for the following series of cash flows: If the firm’s cost of capital is 8%, is the project a good idea? What if the cost of capital is 10%? Example $1,000 C 1 ($5,000) C 0 $2,000 C 2 $3,000 C 3

24. Comparing Projects with Unequal Lives - Example 24 Q: Which of the two following mutually exclusive projects should a firm purchase? Example Short-Lived Project (NPV = $432.82 at an 8% discount rate; IRR = 23.4%) $750 $750 $750 $750 $750 $750 ($2,600) - C 5 - C 4 $750 C 3 Long-Lived Project (NPV = $867.16 at an 8% discount rate; IRR = 18.3%) $750 C 1 ($1,500) C 0 $750 C 2 - C 6 A: The IRR method argues for undertaking the Short-Lived Project while the NPV method argues for the Long-Lived Project. We’ll correct for the unequal life problem by using both the Replacement Chain Method and the EAA Method. Both methods will lead to the same decision.

25. Replacement Chain Method Figure 10.3 25 Thus, buying the Long-Lived Project is a better decision than buying the Short-Lived Project twice.

26. A Three-Year Project Chained into Six Years Figure 10.4 26