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CapitalBudgeting WhatisCapitalBudgeting Thecapitalbudgetingdecisionistheprocessinwhichlongterminvestmentsaregenerated analyzedandundertaken Thegoalofthefirmistomaximizefirmvalue Goodinvestmentdecisionsincreasefirmvalue Maximizingvalue maximizingprofitsHowdoesafirmdecidewhichprojectstoundertake AcceptingpositiveNPVprojectsbenefitstheshareholders Acceptance RejectionCriteria Unsophisticatedmethods Paybackperiod Discountedcashflowmethods Netpresentvalue Internalrateofreturn Profitabilityindex PaybackMethod Notation CFt aftertaxincrementalcashflowinyeart Usuallyt 0istheinitialinvestmentintheproject Paybackperiodisthenumberofyearsittakesafirmtorecoveritsinitialinvestment Define suchthatandletTbethemaximumpaybackperiod Accept reject theprojectif T PaybackMethod Simpletocalculate easytoexplain Popularforsmallbusinessand orsmallprojects Favoursshorttermprojects thereforebiasestowardslowerriskandhigherliquidity Advantages Disadvantages Doesn ttakeintoaccountthetimevalueofmoney Doesn taccountforprojectrisk HowdoesonesetT Doesn tanswerquestion Doesprojectacceptance rejectiondecisionincreasefirmvalue Doesn tuseallcashflows DiscountedPaybackRule Improvesuponthepaybackrulebyaccountingforthetimevalueofmoney Supposekistheappropriateinterestratetodiscountfuturecashflows Andaccept reject projectifpaybackperiodis T NetPresentValue Usingthefirm scostofcapital k theNPViswherethecashflowsmaybepositiveornegative IfNPV 0 firmhasenoughmoneytorepaytheinitialinvestmentatthereturnrequiredbyinvestors PositiveNPVprojectsincreasefirmvalue NetPresentValue Takestakesaccountofthecostofcapital Thereforetakesintoaccounttimevalueofmoney accountsforriskinlongertermprojects UsesallcashflowsProvidesthemostconsistentmeasureforrankingprojectssincetheNPVistheproject scontributiontofirmvalue Advantages Disadvantages Whatiffirmdoesnotknowitsk Rememberthisisonlyanestimateofprojectprofitability InternalRateofReturn TheIRR r istheinterestratewhichsetstheNPVto0Iftheprojectisa traditionalproject negativeoutflowsfollowedbypositiveinflows thenaccept reject theprojectifr k thefirm scostofcapital IRRandNPVComparedIRRandNPVdecisionrulewillalwaysgivesamedecisionforindependentprojects Willnotalwaysgivesameresultsformutuallyexclusiveprojectsifthesizesoftheprojectsareconsiderablydifferentorthetimingofthecashflowsaresignificantlydifferent DisadvantagesCannotbeusedtorank2mutuallyexclusiveprojects AdvantagesCanbeusedifcostofcapitalisunknown Fairlyeasytointerpret InternalRateofReturn 10 WhyCanIRRandNPVGiveDifferentResults IRRassumesthatintermediatecashflowscanbereinvestedattheinternalrateofreturn NPVassumesthatintermediatecashflowscanbereinvestedatthefirm sopportunitycostofcapital AnotherDisadvantageofIRR IRRcalculationsproducemultiplerootswhenthecashflowsinvolvesmorethan1signchange Ifcashflowschangefromnegativetopositivetonegativetopositive cangetpresentvalueprofilegraphsimilartothisgraph NoneoftheIRRshaveanyrealmeaning AndOneLastRankingRule ProfitabilityIndex Ratioofthepresentvalueoffutureexpectedcashflows excludinginitialinvestment dividedbyinitialinvestment DecisionRule Forindependentprojects AcceptprojectifPI 1 AdvantageSimpletocalculate easytoexplain Usesallcashflows Favourssmallerprojects thereforebiasestowardslowerrisk WillgiveconsistentresultstoNPVforindependentprojects Oftenusedtoallocateresourcesifcapitalisrationed DisadvantageCannotbeusedtorankmutuallyexclusiveprojects Giveshigherrankingtosmallerprojects ProfitabilityIndex 14 PresentValueProfile Thepresentvalueprofilegraphsthepresentvalueoftheprojectcashflowsfordifferentinterestrates Longertermprojects wherecashflowsareearnedlater aremoresensitivetochangesininterestratesandaresteeper InterpretingthePresentValueProfileGraph TheinternalrateofreturniswheretheprofilecrossestheXaxis Tomaximizefirmvalue thefirmshouldpicktheprojectwiththehighestNPVfort
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