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Outline
Introduction Discounted Cash Flow (DCF) Techniques
Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)
Recall the Flows of funds and decisions important to the financial manager
Introduction
Capital Budgeting is the process of determining which real investment projects should be accepted and given an allocation of funds from the firm. To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance.
Each requires an estimate of the projects risk so that an appropriate discount rate (opportunity cost of capital) can be determined.
The discussion of risk will be deferred until later. For now, we will assume we know the relevant opportunity cost of capital or discount rate.
Sometimes the above data is difficult to obtain this is the main weakness of all DCF techniques.
Example Project
Initial investment required: $100,000 Opportunity cost of capital: 15% The NPV is
Year Cash Revenues less Expenses after tax
1
2-9
$20,000
$40,000
10
$10,000
Example Project
Initial investment required: $100,000 Opportunity cost of capital: 15% The IRR is
Year Cash Revenues less Expenses after tax
1
2-9
$20,000
$40,000
10
$10,000
$150,000
NPV $100,000 $50,000 $0 10% -$50,000 Discount Rate -$100,000 20% 30% 40% 50% 60% 70% 80% 90% 100%
Weaknesses
Requires knowledge of finance to use. Difficult to calculate need financial calculator. It is possible that there exists no IRR or multiple IRRs for a project and there are several special cases when the IRR analysis needs to be adjusted in order to make a correct decision (these problems will be addressed later).
Example Project
Initial investment required: $100,000 Opportunity cost of capital: 15% The PI is
Year Cash Revenues less Expenses after tax
1
2-9
$20,000
$40,000
10
$10,000
Weaknesses
Requires knowledge of finance to use. It is possible that PI cannot be used if the initial cash flow is an inflow. Method needs to be adjusted when there are mutually exclusive projects (to be discussed later).