CAPITAL BUDGETING & INVESTMENT RULES (L4&5) Flashcards
Capital budgeting
Choosing projects that add value to the company
Independent: selecting one project to invest in doesn’t affect investing in another
Mutually exclusive: selecting one affects another, deciding to buy one coffee machine over a different one (only choosing one of the options)
Net present value
To get cashflows (money from investment) there needs to be an initial investment
Npv= present value of future cash flows- initial investment
To find present value today use the discount rate
NPV tells us the value added to the business (positive is good)
Payback period
Years it takes for the project to pay back the initial investment
Criterion using payback period: for independent projects, accept project if period k is less than threshold (max length)
For mutually exclusive: whichever has quicker payback rate
Payback period cons
Doesn’t account for discount rate, compares different period of times
Cashflows after payback period ignored (NPV may be negative / risk is ignored)
Payback period pros
Simple concept easy to calculate
Shows liquidity of project
Managers think it’ll get them quicker promotion
Discounted payback period
Accounting for the time value of money, how long it takes to get back invested money
Sum of discounted cashflows CF/1+r + CF2/(1+r)^2 etc
Discounted payback period pros & cons
Ignores cashflows after optimal cut off period
Considers time value of money
Internal rate of return
rate of return for each year of the projects life
I0(initial investment)=C1/(1+IRR)^n
Decision criterion using IRR
independent: IRR> opportunity cost of capital
mutually exclusive: highest IRR
single period project
you construct a building for 100000 and expect it to sell for 110000, if the opp cost of capital is 6% do you accept the project?
I0=C1/(1+IRR)
100000=110000/(1+IRR)
1+IRR=1.1
IRR=10%, accept project
multi-period
initial investment=800
cash inflow 300 for 3 years, 150 for 4th year
300/(1+IRR)+300/(1+IRR)^2+300/(1+IRR)^3+150/(!+IRR)^4)-800=0
trial and error
IRR rules for borrowing and lending
when borrowing you want a lower IRR, higher when lending
borrowing is shown by a negative npv
disadvantages of IRR
doesn’t account for the scale of a project so best to us NPV
profitability index
when capital etc is limited, firms want the highest npv possible, PI=net present value/initial investment
independent: PI>0
mutual: highest PI
