FIN3403 Ch9 Presentation

capital budgeting definition:

the process of allocating and budgeting capital (i.e. finding investments with positive NPVs)

3 approaches to evaluating investments:

1. Net Present Value (NPV)

2. Payback Rule (also called Payback Period)

3. Internal Rate of Return (IRR)

Net Present Value (NPV) definition:

the difference between an investment’s market value and its cost

What question does Net Present Value answer?

“how much value is created or destroyed by undertaking this investment?”

NPV equation:

• PV(Future Cash Inflows) – PV(Future Cash Outflows)

• PV of all future cash flows - investments

positive vs negative NPV

• +NPV = good = accept

• -NPV = bad = reject

How should we estimate the value of the business plan?

• Estimate the future cash flows we expect the business to produce

• Apply basic discounted cash flow procedure to estimate the PV of those cash flows

• Estimate NPV as the difference between the PV of the future cash flows and the initial cost

NPVs are:

estimates

payback period:

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

Based on the payback rule, an investment is acceptable if:

the payback period < some prespecified number of years

The NPV of a project is positive $X. If there are Y million shares outstanding, what should the acceptance of this project do to each share’s value?

$X / Y shares = $ per share (i.e. your answer)

disadvantages of the payback period rule:

• time value of money is ignored

• fails to consider any risk differences

• requires an arbitrary cutoff point

• ignores cash flows beyond the cutoff date

• biased against long-term projects

  • SUMMARY: it doesn’t ask the right questions

who uses payback period the majority of the time:

large and sophistcated companies when making relatively minor/small decisions because:

• many decisions do not warrant detailed analysis

• it is biased towards liquidity (short-term projects)

discounted payback period:

• the length of time required for an investment’s discounted cash flows to equal its initial cost

  • if this is positive for a company, then their NPV is also positive

if we use discounted payback, we will not accidentally:

take on a project that has a negative NPV

payback period advantages:

• easy to understand

• adjusts for uncertainty of later cash flows

• biased towards liquidity

What question does Internal Rate of Return answer?

“What percent return am I getting on this investment?”

Based on the IRR, an investment is acceptable if:

IRR >/= the required return

internal rate of return (IRR) definition:

the discount rate that makes the NPV=0

IRR advantages:

• makes it easier to compare project of different sizes

• closely related to NPV, often leading to identical decisions

• easy to understand and communicate

IRR disadvantages

• doesn’t mathematically include the discount rate

• can be misleading when comparing mutual exclusive (“seperate”) projects