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

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1 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 cashflows with and without a project Others (non-revenue) 2. What is meant by unlimited funds? We assume unlimited funds. For most companies this is a fact, but not assumed by management For small companies, funds are scarce. 3. Describe mutually exclusive projects. Accept one; reject others Most projects start as mutually exclusive They end up as independent 4. What is the goal of the financial manager? Wealth maximization 5. What are the basic investment rules? If value >= price buy If expected return >= required return, buy Techniques 6. What does payback period tell us? Time to recover investment Very simple technique (sometimes referred to as unsophisticated) Who uses this type of technique? 7. Why is NPV the superior technique for analyzing projects? It directly measures t5he change in wealth. Not a correct thing, but can think that if you divided NPV by the number of shares, that would approximate the increase in wealth Show how NPV is really Investment Rule #1

2 8. Describe the profitability index. Show how PI is really Investment rule #1 Shows a bang for the buck picture Useful in breaking ties. It can show the best way to manage resources. 9. Economic Value added a Describe IRR. This is the expected return. If you buy the project and the cash flows occur, this is the average return per period. Investment Rule # What can cause techniques to provide conflicting solutions? Time Cash flow magnitude Cash flow timing Reinvestment assumption 12. What methods are generally used by companies? It does not cost more to do them all. Just formulas. NPV is the best (theoretically) IRR is preferred (easier to understand)

3 13. Calculate the capital budgeting solutions for the following techniques: 1. Payback 2. NPV 3. Profitability Index 4. IRR b. The company has decided to purchase a new asset. The expected cost of the project is $195,000. The cost of financing projects is 13%. The expected cash flows follow: 1. 1 $40, $60, $85, $70, $50,000 Investment (CF0) -$195,000 negative CF1 $40,000 CF2 $60,000 CF3 $85,000 CF4 $70,000 CF5 $50,000 CF6 CF7 CF8 Payback Period Discounted Payback Net Present Value $16, IRR % Modified IRR 9.359% Profitability Index 1.084

4 14. The company in problem 13 is considering another project. This one costs $400,000. The cost of financing is the same. The forecasted cash flows are below $70, $100, $120, $145, $100, $80, $70, Using the projects in problems 13 and 14 with the techniques, decide which projects you would do? First, assume both projects are independent. Next, assume they are mutually exclusive. Independent do them both Mutually exclusive project in 14 16) Use the two projects and create the NPV profiles for the projects.

5 Also look at CB: Project Analysis worksheet

6 Complete the following table using the data in this table. 75 points Project A 12% Project B 12% Project C 12%

7 Project A Project B Project C Payback rule Discounted payback rule Discount rate 12% 12% 12% Payback Discounted Payback NPV 6,862 28,991 9,299 IRR PI Accept if independent? Yes / no Payback Yes Yes Yes Discounted Payback no Yes NPV Yes IRR Yes PI Yes Best if mutually exclusive (mark ) Payback Discounted Payback NPV IRR PI

8 Insert the data into the spreadsheet CB:NPV Profile Copy and paste the net Present Value Profile with all three projects. (10) What does the profile illustrate?

9 Insert projects A and C into the worksheet CB Project Analysis (10 points) Which project is preferable? Insert projects B and C into the worksheet CB Project Analysis (10 points) Which project is preferable?