Bruerie

Capital Budgeting

Problem: Bennet Co. Medium Size Fabricator

Expansion A: Reduce costs of production – Cost of $42,000

B: Service a new product line – Cost of $45,000

| Project A | Project B |

Initial Investment Year | | |

1 | 14,000 | 28,000 |

2 | 14,000 | 12,000 |

3 | 14,000 | 10,000 |

4 | 14,000 | 10,000 |

5 | 14,000 | 10,000 |

| NPV = $11,071 | NPV=$10,924 |

Capital Budgeting & Wealth Maximization

1. Capital Gains – P1-Po = increase in stock’s market value

2. Dividends = profit

3. Return = Capital Gains + Dividends

Capital Investment – purchase of future cash flow

KEY PROBLEMS IN INVESTMENT EVALUATION

1. Cash flow

2. Rate

->Risk-free interest rate (Treasury bills) +Risk Premium= reflects high risk, high return concept

Different Methods in Project Evaluation

* Discounted Cash Flow Model

The Net Present Value

NPV =i=1nCFi(1+r)i-IO

*Difference of the sum of the PV of the future project cahs flows and the initial outlay of the investment

NPV Consistent with Shareholder Wealth Maximization?

* NPV is a residual gain, and shareholders are residual owners

* NPV integrated risk in the discount rate

Properties of NPV

* Used to rank projects

* Additive

* Farther out (longer) cash flows have lower value

Internal Rate of Return

IRR : Discount rate which equates the PV of the investment cost to the PV of future cash flow

* Makes NPV equal to 0

* Decision Rule:

* If IRR > required rate of return

* If IRR < required rate of return

Is IRR consistent with SWM? Yes.

Problems with IRR

* Not a reliable procedure for ranking projects

* Violates the principle that relative rankings of investment can change when the cost of capital changes unlike NPW, the IRR is estimated independently of the cost of capital. Hence, rankings remain constant even when the latter changes

* Violates the principle of additivity.

* It can give...