Chapter

Capital Budgeting

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Net Present Value

Net Present Value - Present value of cash flows minus initial investments.

Opportunity Cost of Capital - Expected rate of return given up by investing in a project

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Net Present Value

NPV = PV of all cash inflows - initial investment

C t N P V C 0 t ( 1 r )
C C C 1 2 t N P V C . . . 0 1 2 t ( 1 r )( 1 r ) ( 1 r )
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Net Present Value

Terminology C = Cash Flow and C0 = Initial Investment t = time period of the investment r = opportunity cost of capital

The Cash Flow could be positive or negative at any time period.

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Net Present Value

Net Present Value Rule Managers increase shareholders wealth by accepting all projects that are worth more than they cost.
Therefore, they should accept all projects with a positive net present value.

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Other Investment Criteria

Internal Rate of Return (IRR) - Discount rate at which NPV = 0. IRR is the discount rate that makes your NPV equals to zero thus have the following relationship hold: PV (inflows) = PV (Outflow)

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Internal Rate of Return

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Discounted Payback Period

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Discounted Payback Period

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Profitability Index

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Profitability Index

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Profitability Index

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Problems
1) Johnnys Lunches is considering purchasing a new, energy-efficient grill. The grill will cost $20,000 and will be depreciated according to the 3-year Straight line method. It will be sold for scrap metal after 3 years for $5,000. The grill will have no effect on revenues but will save Johnnys $10,000 in energy expenses. The tax rate is 35 percent. a. What are the operating cash flows in Years 13? b. If the discount rate is 12 percent, should the grill be purchased?
2) Bottoms Up Diaper Service is considering the purchase of a new industrial washer. It can purchase the washer for $6,000 and sell its old washer for $2,000. The new washer will last for 6 years and save $1,500 a year in expenses. The opportunity cost of capital is 15 percent, and the firms tax rate is 40 percent. a. If the firm uses straight-line depreciation to an assumed salvage value of zero over a 6-year life, what are the cash flows of the project in Years 06? The new washer will in fact have zero salvage value after 6 years, and the old washer is fully depreciated. b. What is project NPV? Irwin/McGraw Hill
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