Alternative Investment Rules. Data for Examples

Save this PDF as:
 WORD  PNG  TXT  JPG

Size: px
Start display at page:

Download "Alternative Investment Rules. Data for Examples"

Transcription

1 Alternative Investment Rules (Text reference: Chapter 6) Topics data for examples net present value (NPV) rule internal rate of return (IRR) rule payback rule discounted payback rule average accounting return (AAR) rule profitability index (PI) rule techniques used in practice AFM Alternative Investment Rules Slide 1 Data for Examples we will consider the following projects: Project A: cost at (t = 0) = 200,000 period cash flows 100,000 60, ,000 net income 20,000 30,000 20,000 Project B: cost at (t = 0) = 30,000 period cash flows 20,000 10,000 15,000 net income 6,000 3,000 6,000 Project C: cost at (t = 0) = 200,000 period cash flows 180,000 60,000 10,000 assume a discount rate of 10% for all three projects AFM Alternative Investment Rules Slide 2

2 Net Present Value (NPV) Rule definition: NPV = PV future cash flows cost at t = 0 NPV rule: for independent projects: accept if NPV 0 for mutually exclusive projects: accept project with highest NPV 0 calculate NPV A : NPV A = 23,140, NPV B = 7,716 if independent: choose both A and B if mutually exclusive: choose A AFM Alternative Investment Rules Slide 3 Cont d NPV rule analysis: Advantages Disadvantages - based on cash flow - must forecast all cash flows - considers all cash flows - can be hard to estimate discount rate - discounts cash flows (and incorporates time value of money) notes: accepting positive NPV projects benefits shareholders by increasing the PV of their wealth an NPV profile is useful for analyzing the sensitivity of the NPV to the appropriate discount rate. The profile plots NPV as a function of the discount rate. AFM Alternative Investment Rules Slide 4

3 NPV profile discount rate r 5% 10% 15% 20% NPV A 44,682 23,140 4,652 (11,343) NPV 50,000 40,000 30,000 20,000 10, ,000 5% 10% 15% 20% r AFM Alternative Investment Rules Slide 5 Internal Rate of Return (IRR) Rule definition: IRR is the discount rate which results in NPV = 0 (basic) IRR rule: for independent projects: accept if IRR OCC for mutually exclusive projects: accept project with highest IRR OCC (if the projects are the same size) calculate IRR A : IRR A = 16.4%, IRR B = 25.2% if independent: choose both A and B if mutually exclusive: project sizes differ, so can t tell AFM Alternative Investment Rules Slide 6

4 IRR rule analysis: Advantages Disadvantages - better than alternatives such as payback, AAR - mutually exclusive - scale - more intuitive than NPV - mutually exclusive - timing - coincides with NPV for simple examples - investing vs. financing - single number summary of - multiple IRRs project s profitability - comparison to discount rate with non-flat term structure notes: most important alternative to the NPV approach IRR discount rate NPV 0 (in simple cases) in simple cases, always yields same decision as NPV for independent projects trial and error calculation (like yield to maturity for bonds) AFM Alternative Investment Rules Slide 7 Cont d IRR problem: mutually exclusive - scale affects mutually exclusive project decisions only do you prefer larger $ returns or larger % returns? calculate incremental IRR: AFM Alternative Investment Rules Slide 8

5 IRR problem: mutually exclusive - timing affects mutually exclusive project decisions only discount rate r 5% 10% 15% 20% NPV A 44,682 23,140 4,652 (11,343) NPV C 34,489 20,736 8,466 (2,546) NPV 50,000 40,000 A C 30,000 20,000 10, ,000 5% 10% 15% 20% r AFM Alternative Investment Rules Slide 9 Cont d IRR problem: mutually exclusive - timing calculate incremental IRR: AFM Alternative Investment Rules Slide 10

6 IRR problem: investing/lending vs. financing/borrowing affects mutually exclusive and independent projects consider a project D with cash flows exactly the reverse of project A cash flows (e.g. D = borrowing): we find: period Project A -200, ,000 60, ,000 Project D 200, ,000-60, ,000 NPV A = 23,140, NPV D = 23,140 IRR A = 16.4%, IRR D = 16.4% IRR rule is reversed for financing/borrowing type projects: for investing/lending, rule is accept if IRR OCC for financing/borrowing, rule is accept if IRR OCC note: only works if sign of cash flows changes only once AFM Alternative Investment Rules Slide 11 Cont d IRR problem: multiple IRRs affects mutually exclusive and independent projects consider project E: period Project E -4,000 25,000-25,000 we find two IRRs, IRR E = 25% and 400% (verify that each of these discount rates results in NPV = 0) if sign of cash flows changes n times, there can be n different IRRs which IRR is correct? solution: with changing signs, ignore IRR and use NPV AFM Alternative Investment Rules Slide 12

7 IRR problem: non-flat term structure affects mutually exclusive and independent projects a non-flat term structure implies that discount rates vary depending on the timing of future cash flows recall NPV = T t=0 C t (1 + r t ) t can be hard to compare IRR to the entire term structure of interest rates example: two year project, IRR = 5%, r 1 = 4%, r 2 = 6% solution: if term structure of interest rates is important, ignore IRR and use NPV AFM Alternative Investment Rules Slide 13 Payback Rule definition: the payback period is the time required for an investment to recover its cost payback rule: for independent projects: accept if payback threshold for mutually exclusive projects: accept project with shortest payback threshold calculate payback for Project A: payback A = 2.36 periods, payback B = 2 periods if independent: choose B only if mutually exclusive: choose B only AFM Alternative Investment Rules Slide 14

8 payback rule analysis: Advantages Disadvantages - simple rule (easy to use) - ignores time value of money - may be important for firms - ignores cash flows after threshold with liquidity problems - ignores risk differences between projects - arbitrary payback threshold notes: gives the number of years to recover investment cost becomes unreliable as time value of money becomes more important (i.e. larger number of periods, larger discount rate) AFM Alternative Investment Rules Slide 15 Discounted Payback Rule definition: the discounted payback period is the time required for an investment to recover its cost, after discounting the project cash flows discounted payback rule: for independent projects: accept if discounted payback threshold for mutually exclusive projects: accept project with shortest discounted payback threshold calculate discounted payback for Project A: AFM Alternative Investment Rules Slide 16

9 discounted payback for A = 2.72 periods, for B = 2.32 periods if independent: choose neither if mutually exclusive: choose neither discounted payback period rule analysis: notes: Advantages Disadvantages - simple rule (easy to use) - arbitrary payback threshold - useful for firms - ignores cash flows after threshold with liquidity problems - ignores some risk differences - considers timing of cash flows between projects - can be hard to estimate discount rate discounted payback period > payback period if we have already discounted all cash flows, just use NPV AFM Alternative Investment Rules Slide 17 Average Accounting Return (AAR) Rule definition: AAR is average project earnings after taxes and depreciation, divided by average book value of investment during its life AAR rule: for independent projects: accept project if AAR threshold mutually exclusive projects: accept project with highest AAR threshold calculate AAR for Project A: AFM Alternative Investment Rules Slide 18

10 AAR A = 23.3%, AAR B = 33.3% if independent: choose both A and B if mutually exclusive: choose B average accounting return (AAR) rule analysis: Advantages Disadvantages - simple rule (easy to use) - does not use cash flows - sensitive to accounting methods and estimates - ignores timing of cash flows - arbitrary threshold rate - ignores risk differences between projects AFM Alternative Investment Rules Slide 19 Profitability Index (PI) Rule definition: PI = PI rule: PV of cash flows after initial investment initial investment for independent projects: accept if PI 1 for mutually exclusive projects: accept project with highest PI 1 (if they are the same size) calculate PI for Project A: PI A = 1.12, PI B = 1.26 if independent: choose both A and B if mutually exclusive: project sizes differ, so can t tell AFM Alternative Investment Rules Slide 20

11 PI problem: mutually exclusive - scale affects mutually exclusive project decisions only calculate incremental PI: AFM Alternative Investment Rules Slide 21 Cont d profitability index (PI) rule analysis: Advantages Disadvantages - reflects time value of money - mutually exclusive - ignores scale - considers all cash flows - can be hard to estimate discount rate notes: if PI > 1, then NPV > 0! can overcome the scale problem by looking at PI of incremental cash flows useful when there is capital rationing (i.e. insufficient capital to undertake all desirable projects) rank projects according to PIs, and invest in projects with highest PIs until all capital is used NPV rule is just as easy to use as PI (and doesn t suffer from scale problems) AFM Alternative Investment Rules Slide 22

12 Techniques Used in Practice see text pp based on a 1995 survey of CFOs of large Canadian industrial firms, discounted cash flow methods (IRR, NPV) are the most popular methods payback is also quite popular most firms use NPV or IRR along with payback or AAR payback is most popular among small firms and for firms with CEOs who do not have an MBA firms in industries where cash flows are easier to forecast are more likely to use IRR or NPV AFM Alternative Investment Rules Slide 23

Finance for Cultural Organisations Lecture 7. Net Present Value and Other Investment Criteria

Finance for Cultural Organisations Lecture 7. Net Present Value and Other Investment Criteria Finance for Cultural Organisations Lecture 7. Net Present Value and Other Investment Criteria Lecture 6: Net Present Value and Other Investment Criteria Be able to compute payback and discounted payback

More information

Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of

Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of 1 Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of Return Problems with the IRR Approach The Profitability

More information

Lecture 5 (Chapter 9) Investment Criteria. Some Problems

Lecture 5 (Chapter 9) Investment Criteria. Some Problems Lecture 5 (Chapter 9) Investment Criteria Up to now, we have analyzed how to finance a firm (capital structure) Today we switch to analyzing what to do with the money once we ve got it (capital budgeting

More information

Chapter 2: Capital Budgeting Techniques

Chapter 2: Capital Budgeting Techniques Chapter 2: Introduction 2.1 Introduction In order to assess the feasibility of any investment project, some capital budgeting techniques should be used to evaluate that project. This part illustrates the

More information

Oklahoma State University Spears School of Business. NPV & Other Rules

Oklahoma State University Spears School of Business. NPV & Other Rules Oklahoma State University Spears School of Business NPV & Other Rules Slide 2 Why Use Net Present Value? Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash

More information

1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration.

1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration. Questions in Chapter 9 concept.qz 1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration. [A] Discounted payback analysis [B] The average accounting

More information

Chapter 5 Net Present Value and Other Investment Rules

Chapter 5 Net Present Value and Other Investment Rules University of Science and Technology Beijing Dongling School of Economics and management Chapter 5 Net Present Value and Other Investment Rules Oct. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Be

More information

CAPITAL BUDGETING. Net Present Value and Other Investment Criteria

CAPITAL BUDGETING. Net Present Value and Other Investment Criteria CAPITAL BUDGETING Net Present Value and Other Investment Criteria Net Present Value (NPV) Net present value is the difference between an investment s market value (in today s dollars) and its cost (also

More information

Capital Budgeting: Decision. Example. Net Present Value (NPV) FINC 3630 Yost

Capital Budgeting: Decision. Example. Net Present Value (NPV) FINC 3630 Yost Capital Budgeting: Decision Criteria Example Consider a firm with two projects, A and B, each with the following cash flows and a 10 percent cost of capital: Project A Project B Year Cash Flows Cash Flows

More information

Net Present Value (NPV)

Net Present Value (NPV) Investment Criteria 208 Net Present Value (NPV) What: NPV is a measure of how much value is created or added today by undertaking an investment (the difference between the investment s market value and

More information

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. A payback period less than the project s life means that the NPV is positive for

More information

CFA Level I. Study Session 11. Introduction. Dividends and Share Repurchases: Basics Working Capital Management The Corporate Governance

CFA Level I. Study Session 11. Introduction. Dividends and Share Repurchases: Basics Working Capital Management The Corporate Governance CFA Level I Study Session 11 Reading 36 Reading 37 Reading 38 Reading 39 Reading 40 Reading 41 Introduction Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases: Basics

More information

Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization

Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization! 9.1 Net Present Value! 9.2 The Payback Rule! 9.3 The Average Accounting Return! 9.4 The Internal Rate

More information

Chapter 9: Net Present Value and Other Investment Criteria. Faculty of Business Administration Lakehead University Spring 2003 May 20, 2003

Chapter 9: Net Present Value and Other Investment Criteria. Faculty of Business Administration Lakehead University Spring 2003 May 20, 2003 Chapter 9: Net Present Value and Other Investment Criteria Faculty of Business Administration Lakehead University Spring 2003 May 20, 2003 Outline 9.1 Net Present Value 9.2 The Payback Rule 9.3 The Average

More information

Chapter 7: Net Present Value and Other Investment Criteria

Chapter 7: Net Present Value and Other Investment Criteria FIN 301 Class Notes Chapter 7: Net Present Value and Other Investment Criteria Project evaluation involves: 1- Estimating the cash flows associated with the investment project (ch. 8) 2- Determining the

More information

Which projects should the corporation undertake

Which projects should the corporation undertake Which projects should the corporation undertake Investment criteria 1. Investment into a new project generates a flow of cash and, therefore, a standard DPV rule should be the first choice under consideration.

More information

Chapter 10. Capital Budgeting Techniques. Copyright 2012 Pearson Prentice Hall. All rights reserved.

Chapter 10. Capital Budgeting Techniques. Copyright 2012 Pearson Prentice Hall. All rights reserved. Chapter 10 Capital Budgeting Techniques Copyright 2012 Pearson Prentice Hall. All rights reserved. Overview of Capital Budgeting Capital budgeting is the process of evaluating and selecting long-term investments

More information

Investment Decisions and Capital Budgeting

Investment Decisions and Capital Budgeting Investment Decisions and Capital Budgeting FINANCE 350 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University 1 Issues in Capital Budgeting: Investment How should capital

More information

Net present value is the difference between a project s value and its costs.

Net present value is the difference between a project s value and its costs. 1 2 Net present value is the difference between a project s value and its costs. We need to calculate the Present Value of future cash flows (discounted by the opportunity cost of capital) and subtract

More information

BS2551 Money Banking and Finance

BS2551 Money Banking and Finance S2551 Money anking and Finance Capital udgeting Capital budgeting techniques are decision rules used by managers when undertaking investment decisions. The best techniques should satisfy the following

More information

Project Valuation for Managers

Project Valuation for Managers Project Valuation for Managers An Essential Skill Corporate Finance By Cameron Hall Key Messages The job of managers is to create value. Value in a firm comes from two sources: current operations and new

More information

NPV and Other Investment Criteria

NPV and Other Investment Criteria Chapter 8 NPV and Other Investment Criteria CAPITAL BUDGETING TERMS Capital budgeting is where we start to pull all of the tools and techniques we ve learned so far together (TVM, cash flow analysis, etc.)

More information

$1,300 + 1,500 + 1,900 = $4,700. in cash flows. The project still needs to create another: $5,500 4,700 = $800

$1,300 + 1,500 + 1,900 = $4,700. in cash flows. The project still needs to create another: $5,500 4,700 = $800 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project has created: $1,300 + 1,500 + 1,900 = $4,700 in cash flows.

More information

CHAPTER 8 CAPITAL BUDGETING DECISIONS

CHAPTER 8 CAPITAL BUDGETING DECISIONS CHAPTER 8 CAPITAL BUDGETING DECISIONS Q1. What is capital budgeting? Why is it significant for a firm? A1 A capital budgeting decision may be defined as the firm s decision to invest its current funds

More information

Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions

Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Chapter 8 Capital Budgeting Concept Check 8.1 1. What is the difference between independent and mutually

More information

Investment Decision Analysis

Investment Decision Analysis Lecture: IV 1 Investment Decision Analysis The investment decision process: Generate cash flow forecasts for the projects, Determine the appropriate opportunity cost of capital, Use the cash flows and

More information

Chapter 11. Investment Decision Criteria. Copyright 2011 Pearson Prentice Hall. All rights reserved.

Chapter 11. Investment Decision Criteria. Copyright 2011 Pearson Prentice Hall. All rights reserved. Chapter 11 Investment Decision Criteria Chapter 11 Contents Learning Objectives Principles Used in This Chapter 1. An Overview of Capital Budgeting 2. Net Present Value 3. Other Investment Criteria 4.

More information

For 9.220, Term 1, 2002/03 02_Lecture9.ppt. Introduction Problems with IRR Special Considerations for DCF Techniques

For 9.220, Term 1, 2002/03 02_Lecture9.ppt. Introduction Problems with IRR Special Considerations for DCF Techniques Capital Budgeting For 9.22, Term, 22/3 2_Lecture9.ppt Outline Introduction Problems with IRR Special Considerations for DCF Techniques Mutually Exclusive Projects Capital Rationing Non-Discounted Cash

More information

Key Concepts and Skills. Net Present Value and Other Investment Rules. http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf.

Key Concepts and Skills. Net Present Value and Other Investment Rules. http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf. McGraw-Hill/Irwin Net Present Value and Other Investment Rules 9-1 http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf Copyright 2010 by Charles Hodges and the McGraw-Hill Companies, Inc. All rights

More information

USQ UNIVERSITY OF SOUTHERN QUEENSLAND

USQ UNIVERSITY OF SOUTHERN QUEENSLAND USQ UNIVERSITY OF SOUTHERN QUEENSLAND MBA - ACC5502 Accounting & Financial Management / S1 / 2015 M B G Wimalarathna [FCA, FCMA, MCIM, FMAAT, MCPM, (MBA PIM/USJ)] Introduction Decision on long term investments

More information

Net Present Value and Capital Budgeting. What to Discount

Net Present Value and Capital Budgeting. What to Discount Net Present Value and Capital Budgeting (Text reference: Chapter 7) Topics what to discount the CCA system total project cash flow vs. tax shield approach detailed CCA calculations and examples project

More information

Project Evolution & Estimation :cash flow forecasting, cost benefit evolution techniques, risk evolution, Cost benefit analysis

Project Evolution & Estimation :cash flow forecasting, cost benefit evolution techniques, risk evolution, Cost benefit analysis Project Evolution & Estimation :cash flow forecasting, cost benefit evolution techniques, risk evolution, Cost benefit analysis EA Cost-benefit Analysis A standard way to assess the economic benefits Two

More information

Economic Feasibility Studies

Economic Feasibility Studies Economic Feasibility Studies ١ Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. The difficulty with making these decisions

More information

Corporate Finance. Slide 1 咨询热线 : 学习平台 : lms.finance365.com

Corporate Finance. Slide 1 咨询热线 : 学习平台 : lms.finance365.com Corporate Finance Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases Working capital management Corporate Governance of Listed Companies Slide 1 Capital Budgeting Slide

More information

USQ UNIVERSITY OF SOUTHERN QUEENSLAND

USQ UNIVERSITY OF SOUTHERN QUEENSLAND USQ UNIVERSITY OF SOUTHERN QUEENSLAND MBA - ACC5502 Accounting & Financial Management / S1 / 2013 M B G Wimalarathna (ACA, ACMA, ACIM, SAT, ACPM)(MBA USJ/PIM) Introduction Key management personnel of an

More information

Chapter 8 Capital Budgeting Process and Techniques

Chapter 8 Capital Budgeting Process and Techniques Chapter 8 Capital Budgeting Process and Techniques MULTIPLE CHOICE 1. The capital budgeting process involves a. identifying potential investments b. analyzing the set of investment opportunities, and identifying

More information

Capital Budgeting Capital Budgeting The process by which a business

Capital Budgeting Capital Budgeting The process by which a business Capital Budgeting 1 Capital Budgeting The process by which a business chooses which investments to make in capital equipment 2 Capital Investments Money markets: Short term Capital markets: Long term Capital

More information

Answers to Concepts Review and Critical Thinking Questions

Answers to Concepts Review and Critical Thinking Questions Answers to Concepts Review and Critical Thinking Questions 1. A payback period less than the project s life means that the NPV is positive for a zero discount rate, but nothing more definitive can be said.

More information

Investment Decisions. Investment Decision Making. Competitors/Alternatives to the NPV Rule. Implementing the NPV Rule. Payback rule--misleading

Investment Decisions. Investment Decision Making. Competitors/Alternatives to the NPV Rule. Implementing the NPV Rule. Payback rule--misleading Investment Decisions Investment Decision Making Fisher Model Criteria - Production or Real Investment chosen to maximize Wealth (= present discounted stream of consumption) Econ 422: Investment, Capital

More information

Solutions to Chapter 8. Net Present Value and Other Investment Criteria

Solutions to Chapter 8. Net Present Value and Other Investment Criteria Solutions to Chapter 8 Net Present Value and Other Investment Criteria. NPV A = $00 + [$80 annuity factor (%, periods)] = $00 $80 $8. 0 0. 0. (.) NPV B = $00 + [$00 annuity factor (%, periods)] = $00 $00

More information

Capital Budgeting. Finance 100

Capital Budgeting. Finance 100 Capital Budgeting Finance 100 Prof. Michael R. Roberts 1 Topic Overview How should capital be allocated?» Do I invest / launch a product / buy a building / scrap / outsource...» Should I acquire / sell

More information

Chapter 7. Net Present Value and Other Investment Criteria

Chapter 7. Net Present Value and Other Investment Criteria Chapter 7 Net Present Value and Other Investment Criteria 7-2 Topics Covered Net Present Value Other Investment Criteria Mutually Exclusive Projects Capital Rationing 7-3 Net Present Value Net Present

More information

HO-23: METHODS OF INVESTMENT APPRAISAL

HO-23: METHODS OF INVESTMENT APPRAISAL HO-23: METHODS OF INVESTMENT APPRAISAL After completing this exercise you will be able to: Calculate and compare the different returns on an investment using the ROI, NPV, IRR functions. Investments: Discounting,

More information

(Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics)

(Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) Y O Lam Capital budgeting assists decision makers in a

More information

2) A project should automatically be accepted when the project's base case net present value is positive.

2) A project should automatically be accepted when the project's base case net present value is positive. Questions Chapter 11 1) Given a tax rate of zero, the accounting break-even point for a project: [A] indicates when the net present value turns positive. [B] excludes depreciation in its computation. [C]

More information

Capital Budgeting Tools. Chapter 11. Capital Budgeting. Types of Capital Budgeting Projects. The Basics of Capital Budgeting: Evaluating Cash Flows

Capital Budgeting Tools. Chapter 11. Capital Budgeting. Types of Capital Budgeting Projects. The Basics of Capital Budgeting: Evaluating Cash Flows Capital Budgeting Tools () Payback Period (a) Discounted Payback Period Chapter The Basics of Capital Budgeting: Evaluating s () Net Present Value (NPV) (a) Profitability Index (PI) () Internal Rate of

More information

5. What are the basic investment rules? If value >= price buy If expected return >= required return, buy

5. What are the basic investment rules? If value >= price buy If expected return >= required return, buy BUA321 Chapter 10 Class Notes Capital Budgeting Techniques 1. What kinds of projects are analyzed with capital budgeting? Expansion (easiest to forecast) Replacement (more complicated) We must forecast

More information

WHAT IS CAPITAL BUDGETING?

WHAT IS CAPITAL BUDGETING? WHAT IS CAPITAL BUDGETING? Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial

More information

CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation

CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation Should we build this plant? 10-1 Capital Budgeting Overview Project Classifications Analysis Methods/Decision Rules Comparison of

More information

Net Present Value and Other Investment Criteria

Net Present Value and Other Investment Criteria Net Present Value and Other Investment Criteria Topics Covered Net Present Value Other Investment Criteria Mutually Exclusive Projects Capital Rationing Net Present Value Net Present Value - Present value

More information

Introduction to Discounted Cash Flow and Project Appraisal. Charles Ward

Introduction to Discounted Cash Flow and Project Appraisal. Charles Ward Introduction to Discounted Cash Flow and Project Appraisal Charles Ward Company investment decisions How firms makes investment decisions about real projects (not necessarily property) How to decide which

More information

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 13-1 a. The capital budget outlines the planned expenditures on fixed assets. Capital budgeting

More information

Finance Theory

Finance Theory Finance Theory MIT Sloan MBA Program Andrew W. Lo Harris & Harris Group Professor, MIT Sloan School Lectures 18 20 20: : Capital Budgeting Critical Concepts NPV Rule Cash Flow Computations Discount Rates

More information

MCQ of Corporate Finance

MCQ of Corporate Finance MCQ of Corporate Finance 1. Which of the following is not one of the three fundamental methods of firm valuation? a) Discounted Cash flow b) Income or earnings - where the firm is valued on some multiple

More information

MODULE 2. Capital Budgeting

MODULE 2. Capital Budgeting MODULE 2 Capital Budgeting Capital Budgeting is a project selection exercise performed by the business enterprise. Capital budgeting uses the concept of present value to select the projects. Capital budgeting

More information

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. Assuming conventional cash flows, a payback period less than the project s life means

More information

Capital Investment Appraisal Techniques

Capital Investment Appraisal Techniques Capital Investment Appraisal Techniques To download this article in printable format click here A practising Bookkeeper asked me recently how and by what methods one would appraise a proposed investment

More information

Year Project A Project B 0 (50 000) (50 000)

Year Project A Project B 0 (50 000) (50 000) Al Imam Mohammad Ibn Saud Islamic University College of Economics and Administrative Sciences Department of Finance and Investment Level 4: All branches Investment Decision Under Certainty Exercise 1 A

More information

Chapter 5 Capital Budgeting

Chapter 5 Capital Budgeting Chapter 5 Capital Budgeting Road Map Part A Introduction to finance. Part B Valuation of assets, given discount rates. Fixed-Income securities. Common stocks. Real assets (capital budgeting). Part C Determination

More information

Financial and Cash Flow Analysis Methods. www.project-finance.com

Financial and Cash Flow Analysis Methods. www.project-finance.com Financial and Cash Flow Analysis Methods Financial analysis Historic analysis (BS, ratios, CF analysis, management strategy) Current position (environment, industry, products, management) Future (competitiveness,

More information

PAYBACK PERIOD. Calculated as: Payback Period = Cost of Project / Annual Cash Inflows

PAYBACK PERIOD. Calculated as: Payback Period = Cost of Project / Annual Cash Inflows PAYBACK PERIOD CHRISTINE NYANDAT, 19 Nov, 2013 Definition: Payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an

More information

Prioritization of Climate Change Adaptation Options. The Role of Cost-Benefit Analysis. Session 7: Conducting CBA Step 6

Prioritization of Climate Change Adaptation Options. The Role of Cost-Benefit Analysis. Session 7: Conducting CBA Step 6 Prioritization of Climate Change Adaptation Options The Role of Cost-Benefit Analysis Session 7: Conducting CBA Step 6 Accra (or nearby), Ghana October 25 to 28, 2016 8 steps Step 1: Define the scope of

More information

Chapter 10. What is capital budgeting? Topics. The Basics of Capital Budgeting: Evaluating Cash Flows

Chapter 10. What is capital budgeting? Topics. The Basics of Capital Budgeting: Evaluating Cash Flows Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows 1 Topics Overview and vocabulary Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life 2 What

More information

FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored

FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored Find needed answers here - http://uoptutor.com/product/fin-534-quiz-8-30-questions-withanswers-9999-scored/ FIN 534 Quiz 8 (30 questions with answers)

More information

Chapter 7. What s next? Topic Overview. Net Present Value & Other Investment Criteria

Chapter 7. What s next? Topic Overview. Net Present Value & Other Investment Criteria What s next? Capital Budgeting: involves making decisions about real asset investments. Chapter 7: Net Present Value and Other Investment Criteria Chapter 8: Estimating cash flows for a potential investment.

More information

First Encounter with Capital Budgeting Rules EC Borja Larrain

First Encounter with Capital Budgeting Rules EC Borja Larrain First Encounter with Capital Budgeting Rules EC 1745 Borja Larrain Today: 1. NPV as the golden rule. 2. The IRR. 3. Other Investment Rules. Readings: Chapter 4 Welch Assignment 1 due next class (09/29).

More information

Chapter 9. Capital Budgeting Techniques

Chapter 9. Capital Budgeting Techniques Chapter 9 Capital Budgeting Techniques 1 Learning Outcomes Chapter 9 Describe the importance of capital budgeting decisions and the general process that is followed when making investment (capital budgeting)

More information

MBA 8130 FOUNDATIONS OF CORPORATION FINANCE FINAL EXAM VERSION A

MBA 8130 FOUNDATIONS OF CORPORATION FINANCE FINAL EXAM VERSION A MBA 8130 FOUNDATIONS OF CORPORATION FINANCE FINAL EXAM VERSION A Fall Semester 2004 Name: Class: Day/Time/Instructor:. Read the following directions very carefully. Failure to follow these directions will

More information

NPV Versus IRR. W.L. Silber -1000 0 0 +300 +600 +900. We know that if the cost of capital is 18 percent we reject the project because the NPV

NPV Versus IRR. W.L. Silber -1000 0 0 +300 +600 +900. We know that if the cost of capital is 18 percent we reject the project because the NPV NPV Versus IRR W.L. Silber I. Our favorite project A has the following cash flows: -1 + +6 +9 1 2 We know that if the cost of capital is 18 percent we reject the project because the net present value is

More information

Answers to Warm-Up Exercises

Answers to Warm-Up Exercises Answers to Warm-Up Exercises E10-1. Answer: E10-2. Answer: Payback period The payback period for Project Hydrogen is 4.29 years. The payback period for Project Helium is 5.75 years. Both projects are acceptable

More information

How to use NPV to your Advantage

How to use NPV to your Advantage How to use NPV to your Advantage Why Simple Payback isn t always fair Eric A. Woodroof, Ph.D. www.profitablegreensolutions.com April 2011 Most facility managers use Simple Payback to evaluate and prioritize

More information

Review Solutions FV = 4000*(1+.08/4) 5 = $4416.32

Review Solutions FV = 4000*(1+.08/4) 5 = $4416.32 Review Solutions 1. Planning to use the money to finish your last year in school, you deposit $4,000 into a savings account with a quoted annual interest rate (APR) of 8% and quarterly compounding. Fifteen

More information

Introduction to Bond Valuation. Types of Bonds

Introduction to Bond Valuation. Types of Bonds Introduction to Bond Valuation (Text reference: Chapter 5 (Sections 5.1-5.3, Appendix)) Topics types of bonds valuation of bonds yield to maturity term structure of interest rates more about forward rates

More information

Industrial and investment analysis as a tool for regulation

Industrial and investment analysis as a tool for regulation Industrial and investment analysis as a tool for regulation Marina Di Giacomo, Università di Torino Turin School of Local Regulation International Summer School on Regulation of Local Public Services 1

More information

Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14

Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14 Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14 I. Additional Issues in Capital Budgeting. A. Capital rationing: Use profitability index

More information

BF 6701 : Financial Management Comprehensive Examination Guideline

BF 6701 : Financial Management Comprehensive Examination Guideline BF 6701 : Financial Management Comprehensive Examination Guideline 1) There will be 5 essay questions and 5 calculation questions to be completed in 1-hour exam. 2) The topics included in those essay and

More information

Lecture 7 - Capital Budgeting: Decision Criteria

Lecture 7 - Capital Budgeting: Decision Criteria Lecture 7 - Capital Budgeting: Decision Criteria What is Capital Budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to a firm s future. The Ideal

More information

1. What are the three types of business organizations? Define them

1. What are the three types of business organizations? Define them Written Exam Ticket 1 1. What is Finance? What do financial managers try to maximize, and what is their second objective? 2. How do you compare cash flows at different points in time? 3. Write the formulas

More information

Capital investments are long-term investments

Capital investments are long-term investments Capital Budgeting Basics File C5-240 August 2013 www.extension.iastate.edu/agdm Capital investments are long-term investments in which the assets involved have useful lives of multiple years. For example,

More information

Chapter 9 Capital Budgeting Decision Models

Chapter 9 Capital Budgeting Decision Models Chapter 9 Capital Budgeting Decision Models LEARNING OBJECTIVES (Slide 9-2) 1. Explain capital budgeting and differentiate between short-term and long-term budgeting decisions. 2. Explain the payback model

More information

6 Investment Decisions

6 Investment Decisions 6 Investment Decisions After studying this chapter you will be able to: Learning Objectives Define capital budgeting and explain the purpose and process of Capital Budgeting for any business. Explain the

More information

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Basic 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After two years, the

More information

Overview of Lecture 8

Overview of Lecture 8 Overview of Lecture 8 Stock Pricing Present Value of Growth Opportunities (PVGO) PE ratios and what they tell us Alternative Measures of Value (Lecture 6 in Reader book & Chpt. 5 in B&M textbook) M. Spiegel

More information

Capital Budgeting Further Considerations

Capital Budgeting Further Considerations Capital Budgeting Further Considerations For 9.220, Term 1, 2002/03 02_Lecture10.ppt Lecture Outline Introduction The input for evaluating projects relevant cash flows Inflation: real vs. nominal analysis

More information

Strategy and Analysis in Using NPV. How Positive NPV Arises

Strategy and Analysis in Using NPV. How Positive NPV Arises Strategy and Analysis in Using NPV (Text reference: Chapter 8) Topics how positive NPV arises decision trees sensitivity analysis scenario analysis break-even analysis investment options AFM 271 - Strategy

More information

CHAPTER 29. Capital Budgeting

CHAPTER 29. Capital Budgeting CHAPTER 9 Capital Budgeting Meaning The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the purpose of maximizing return on investments. The capital

More information

Midterm exam financiering/finance. <Front page>

Midterm exam financiering/finance. <Front page> Midterm exam financiering/finance Question 1 An agency problem can be alleviated by: A) requiring all organizations to be sole proprietorships. B) compensating managers in such a way that

More information

Course Schedule. SECTION 1. (Day 1 Morning) Introduction Registration Course Description Classroom Rules & Procedures

Course Schedule. SECTION 1. (Day 1 Morning) Introduction Registration Course Description Classroom Rules & Procedures Course Schedule SECTION 1. (Day 1 Morning) Introduction Registration Course Description Classroom Rules & Procedures Part 1. Introduction and Overview Diagnostic Quiz (Participants work the problems) Diagnostic

More information

1 (a) Calculation of net present value (NPV) Year 1 2 3 4 5 6 $000 $000 $000 $000 $000 $000 Sales revenue 1,600 1,600 1,600 1,600 1,600

1 (a) Calculation of net present value (NPV) Year 1 2 3 4 5 6 $000 $000 $000 $000 $000 $000 Sales revenue 1,600 1,600 1,600 1,600 1,600 Answers Fundamentals Level Skills Module, Paper F9 Financial Management December 2011 Answers 1 (a) Calculation of net present value (NPV) Year 1 2 3 4 5 6 $000 $000 $000 $000 $000 $000 Sales revenue 1,600

More information

Investment Appraisal

Investment Appraisal Investment Appraisal Article relevant to F1 Business Mathematics and Quantitative Methods Author: Pat McGillion, current Examiner. Questions 1 and 6 often relate to Investment Appraisal, which is underpinned

More information

Level 6 Advanced Diploma in Finance (531) 126 Credits

Level 6 Advanced Diploma in Finance (531) 126 Credits Level 6 Advanced Diploma in Finance (531) 126 Credits Unit: Finance Theory Guided Learning Hours: 210 Exam Paper No.: 4 Prerequisites: Knowledge of Finance. Number of Credits: 21 Corequisites: A pass or

More information

UNIVERSITY OF WAH Department of Management Sciences

UNIVERSITY OF WAH Department of Management Sciences BBA-330: FINANCIAL MANAGEMENT UNIVERSITY OF WAH COURSE DESCRIPTION/OBJECTIVES The module aims at building competence in corporate finance further by extending the coverage in Business Finance module to

More information

CORPORATE FINANCE EVENT PARTICIPANT INSTRUCTIONS

CORPORATE FINANCE EVENT PARTICIPANT INSTRUCTIONS CAREER CLUSTER Finance CAREER PATHWAY Corporate Finance INSTRUCTIONAL AREA Financial Analysis CORPORATE FINANCE EVENT PARTICIPANT INSTRUCTIONS PROCEDURES 1. The event will be presented to you through your

More information

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project

More information

Chapter 8. Capital Budgeting Cash Flows. Learning Goals. Learning Goals (cont.)

Chapter 8. Capital Budgeting Cash Flows. Learning Goals. Learning Goals (cont.) Chapter 8 Capital Budgeting Cash Flows Learning Goals 1. Understand the motives for key capital budgeting expenditures and the steps in the capital budgeting process. 2. Define basic capital budgeting

More information

Chapter 11. Investment Decision Criteria. Copyright 2011 Pearson Prentice Hall. All rights reserved.

Chapter 11. Investment Decision Criteria. Copyright 2011 Pearson Prentice Hall. All rights reserved. Chapter 11 Investment Decision Criteria Chapter 11 Contents Learning Objectives Principles Used in This Chapter 1. An Overview of Capital Budgeting 2. Net Present Value 3. Other Investment Criteria 4.

More information

BUSINESS FINANCE (FIN 312) Spring 2009

BUSINESS FINANCE (FIN 312) Spring 2009 BUSINESS FINANCE (FIN 31) Spring 009 Assignment Instructions: please read carefully You can either do the assignment by yourself or work in a group of no more than two. You should show your work how to

More information

STRAYER FIN 534 Week 7 Quiz 6 Click Here to Buy the Tutorial http://www.tutorialrank.com/fin/strayer-fin-534/product- 6961-strayer-fin-534-week-7-quiz-6 For more course tutorials visit www.tutorialrank.com

More information

In Feb. 2000, Corning Inc., announced plans to spend $750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component

In Feb. 2000, Corning Inc., announced plans to spend $750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component CAPITAL BUDGETING In Feb. 2000, Corning Inc., announced plans to spend $750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component of today s high speed communications

More information

Methodology for performing a financial/economic feasibility analysis

Methodology for performing a financial/economic feasibility analysis Methodology for performing a financial/economic feasibility analysis Papadimitriou, Stratos Chlomoudis, Costas Koliousis, Ioannis Department of Maritime Studies University of Piraeus What Project Appraisal

More information