Questions and Answers
What is capital budgeting?
The ___ is the period of time required to recover the funds expended in an investment.
Payback period
What is the main advantage of projects that offer earlier returns according to the Time Value of Money concept?
They are preferable
Match the projects evaluation method with its description:
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What does PI stand for in the context of International Capital Budgeting?
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What does NPV stand for in the context of International Capital Budgeting?
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What action is generally taken if the Profitability Index (PI) is greater than 1?
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What is the formula to calculate Profitability Index (PI)?
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Political risk refers to the risk an investment's returns could suffer due to political instability in a country.
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Market imperfections in real-world markets include competition for market share, high barriers to entry and exit, and prices set by ___ rather than by supply and demand.
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Study Notes
International Capital Budgeting
- Capital budgeting is a process of evaluating and selecting projects or investments to create value for shareholders.
- Time value of money: a dollar today is worth more than a dollar in the future.
- Projects evaluation methods:
- Payback period: the period of time required to recover the funds expended in an investment.
- Discounted payback period: the period of time required to recover the funds expended in an investment, considering the time value of money.
- Net present value (NPV): the difference between the present value of cash inflows and the present value of cash outflows.
- Internal rate of return (IRR): the rate at which the net present value of all cash flows from a project or investment equal zero.
- Profitability index (PI): the ratio of the present value of cash inflows to the present value of cash outflows.
Payback Period
- The payback period is the time it takes for an investment to generate cash flows equal to the initial investment.
- Accept a project if the expected payback period is less than or equal to the required payback period.
- Reject a project if the expected payback period is more than the required payback period.
Discounted Payback Period
- The discounted payback period is the time it takes for an investment to generate cash flows equal to the initial investment, considering the time value of money.
- Accept a project if the discounted payback period is less than or equal to the required payback period.
- Reject a project if the discounted payback period is more than the required payback period.
Net Present Value (NPV)
- NPV is the difference between the present value of cash inflows and the present value of cash outflows.
- Accept a project if NPV is greater than zero.
- Reject a project if NPV is less than zero.
- Indifferent if NPV is equal to zero.
Internal Rate of Return (IRR)
- IRR is the rate at which the net present value of all cash flows from a project or investment equal zero.
- Accept a project if IRR is greater than or equal to the cost of capital.
- Reject a project if IRR is less than the cost of capital.
Profitability Index (PI)
- PI is the ratio of the present value of cash inflows to the present value of cash outflows.
- Accept a project if PI is greater than or equal to one.
- Reject a project if PI is less than one.
International Capital Budgeting
- Foreign exchange risks: the risk of changes in exchange rates affecting the value of an investment.
- Political risks: the risk of changes in government policies affecting the value of an investment.
- Market imperfections: the risk of imperfect markets affecting the value of an investment.
- Expanded opportunity set: the benefit of investing internationally, allowing for diversification and potentially higher returns.
Case Study
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A company is considering an investment in Germany, with an initial cost of €35,000,000.
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The cash flows for the project are:
- Year 2024: €10,000,000
- Year 2025: €14,000,000
- Year 2026: €18,000,000
- Year 2027: €21,000,000
- Year 2028: €25,000,000
- Year 2029: €35,000,000
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The exchange rate is 19.5 E.P. per EURO.
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The cost of capital is 11%.
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The required payback period is 5 years.
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The required discounted payback period is 5 years.
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The investment decision is:
- Accept the project, as the payback period is less than 5 years.
- Accept the project, as the discounted payback period is less than 5 years.
- Accept the project, as the NPV is greater than zero.
- The project will increase the market value of common stock, as the NPV is positive.### International Capital Budgeting
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The investment decision is accepted because the discounted payback period for this project is less than the required payback period.
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The project increases the Stockholder Wealth Maximization by adding $ 963,066,170.1 to the corporate value, with a Net Present Value (NPV) of $ 963,066,170.1 EGP.
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The project positively impacts the market value of shares, increasing it to $ 642.02, if the stock exchange is efficient.
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The new market value of shares is calculated as $ 120 + ($ 963,066,170.1 ÷ 1,500,000) = $ 120 + $ 642.02 = $ 862.02 EGP.
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