CAPITAL BUDGETING Cost of Capital Evaluating Cash Flows Payback‚ discounted payback NPV IRR‚ MIRR The Cost of Capital • Cost of Capital Components – Debt – Common Equity • WACC Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So‚ we should focus on marginal costs. What types of long-term capital do organizations use? nLong-term debt nEquity Weighted
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and comparison of project appraisal techniques. The Net Present Value (NPV) method is used by 75% of firms when deciding on investment projects. The reasons for its wide use is that firstly‚ the NPV rule takes into account the time value of money‚ meaning that it recognises that a pound today is worth more than a pound tomorrow as the pound today can be invested to start earning interest immediately. Secondly‚ NPV depends solely on the forecasted cash flows from the project and the opportunity
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project’s IRR increases as the cost of capital declines. b. All else equal‚ a project’s NPV increases as the cost of capital declines. c. All else equal‚ a project’s MIRR is unaffected by changes in the cost of capital. d. Statements a and b are correct. e. Statements b and c are correct. Ranking conflicts 2. Answer: a Diff: E Which of the following statements is most correct? a. The NPV method assumes that cash flows will be reinvested at the cost of capital‚ while the IRR method
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NPVs are easy to determine using a calculator with an NPV function. NPVL = $18.78 and NPVS = $19.98. Answer 2: The rationale behind the NPV method is straightforward: if a project has NPV = $0‚ then the project generates exactly enough cash flows to recover the cost of the investment and to enable investors to earn their required rates of return (the opportunity cost of capital). If NPV = $0‚ then in a financial (but not an accounting) sense‚ the project breaks even. If the NPV is positive
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capital budgeting tools a firm can use in analyzing a capital expenditure. They are: net present value (NPV)‚ internal rate of return (IRR)‚ profitability index (PI)‚ payback period (PB)‚ discounted payback period (DRP)‚ and modified internal rate of return (MIRR). This case study will focus mainly on NPV and IRR‚ in addition to the remaining four capital budgeting tools. Net Present Value (NPV) The NPV of an investment proposal for a project is the same as the” present value of its annual free cash
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three years‚ which projects would you accept? “A‚ B‚ C” All the projects meet the given cutoff period‚ thus‚ every project (A‚ B‚ C) is acceptable. (In terms of NPV‚ since B has the highest NPV‚ B is the best option.) d. If the opportunity cost of capital is 10%‚ which projects have positive NPVs? “B & C” have the positive NPV at the capital cost of 10%. e.“If a firm uses a single cutoff period for all projects‚ it is likely to accept too many short- lived projects.” True or false?
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---------------------------------------- PART B: NPV &IRR LATHE A NPV & IRR LATHE B NPV & IRR years cash flow PV Factor @13% PV cash flows PV Factor @13% PV 0 (660‚000) 1 (660‚000) (360‚000) 1 (360‚000) 1 128‚000 0.885 113‚274 88‚000 0.885 77‚876 2 182‚000 0.783 142‚533 120‚000 0.783 93‚978 3 166‚000 0.693 115‚046 96‚000 0.693 66‚533 4 168‚000 0.613 103‚038 86‚000 0.613 52‚745 5 450‚000 0.543 244‚242 207‚000 0.543 112‚351 NPVA 58‚133 NPVB 43‚483 IRRA 16% IRRB 17% ACCEPTABILTY OF EACH PROJECT: Under the NPV calculations both
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A Comparison of Capital Budgeting Techniques Capital budgeting deals with setting the criteria and prescribing the process required for making capital investment choices. Choosing an investment project‚ that is‚ making a capital investment choice is ultimately a cost/benefit analysis. It requires valuing the project by comparing the payoff to its costs. Problem Value‚ rank and select investment projects Example 1. Project A Required rate year 1: year 2 year 3 year 4 year 5 Initial
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with different 5-year projections of cash flows. The evaluation done to the two corporations (A and B) is based on the Net Present Value (NPV) and the Internal Rate of Return (IRR). The net present value represents the value the project or investment adds to the investor wealth. The NPV method of capital budgeting suggests that all projects that have positive NPV should be accepted because they would add value to the investment. On the other hand‚ the internal rate of return is defined as the discount
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comparison of NPV & Other investment rules Comparison of NPV & Other Investment Rules Capital budgeting is important for a company to make decisions on investments and financing issues. However‚ there are various methods can be used for corporate financing‚ among which Net Present Value (NPV) is the best rule which can always lead to the correct choices. Except NPV‚ the company can also use payback period‚ discounted payback period method‚ the internal rate of return (IRR) and the profitability
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