Capital Budgeting Lecture 1 PDF

FIN 405 - Capital Investment and Financing Decisions Professor Paulo Capital Budgeting 1  A Few Important Things Read the syllabus carefully! OHs: By appointment Course Assignments: 1. 2 Exams (30%+35%)  The final exam score will replace the midte...

FIN 405 - Capital Investment and Financing Decisions Professor Paulo Capital Budgeting 1  A Few Important Things Read the syllabus carefully! OHs: By appointment Course Assignments: 1. 2 Exams (30%+35%)  The final exam score will replace the midterm score whenever this improves a student’s total grade 2. Casework (20%) 3. Case Quizzes (5%) 4. General Quizzes (10%) Documented disability: Please let me know ASAP Case Study and Attendance Policy Case discussion: in-person Attendance on case days is mandatory! Unexcused absence may result in deductions. Excused absence (other than unexpected sickness) should be reported to me at least 2 days before the case. I might require supporting documentation to accept your excused absence.  Case Study Material Fiscal copies: Jonhy Print Online copies: http://store.darden.virginia.edu/ Must read before case discussion!  Attendance Monitoring In order to meet federal regulations, I need to monitor student participation I’ll take online attendance on September 5th If you are unable to attend the section, please let me know via email Choice of Projects  Choice of Projects +3.8M +0.9M +1M +1M +1M 1 year 1 year 1 year 1 year 3 years -3M -3M  Capital Budgeting Firms have huge number of possible investments Basic decision of the firm: where to invest? Scarce capital => allocation matters! How to decide?  Capital Budgeting Cash-flow based Payback Net Present Value (NPV) Internal Rate of Return Other non-cash flow (accounting based) Average accounting return  Payback Payback Period Number of years it takes before the cumulative forecasted cash flow equals the initial outlay Payback Rule: select Projects with payback in desired time frame; or Projects with shortest payback period  Choice of Projects +3.8M +0.9M +1M +1M +1M 1 year 1 year 1 year 1 year 3 years -3M -3M  Net Present Value Project require investment. Assume: 1. Known cashflow 2. Same risk benchmark project has return  Net Present Value Example: project pay $1M in 1 year, requiring $850k of investment. Cost of capital is 10%.  Net Present Value General concept: Estimate all net cash flows, positive and negative Estimate project’s cost of capital Find the present value of the cash flows Discount all N future cash flows: 𝑵𝑪𝑭𝟏 𝑵𝑪𝑭𝟐 𝑵𝑪𝑭𝑵 NPV = 𝟎 𝟏 𝒓 𝟏 𝒓 𝟐 𝟏 𝒓 𝑵 NPV > 0 : Accept NPV < 0 : Reject  Net Present Value Example: project pay $1M in 1 year and $1M in 2 years, requiring $850k of investment now. Cost of capital is 10%.  Example: Annuity Annuity: security paying a constant cashflow C at the end of each periods for n periods. 𝑪 𝑪 𝑪 𝟏 𝒓 𝟏 𝒓 𝟐 𝟏 𝒓 𝒏  Example: Annuity Annuity: security paying a constant cashflow C at the end of each periods for n periods. 𝑪 𝑪 𝑪 𝟏 𝒓 𝟏 𝒓 𝟐 𝟏 𝒓 𝒏 𝑪 𝟏 𝟏 𝟐 𝟏 𝒏 𝟏 𝟏 𝒓 𝟏 𝒓 𝟏 𝒓 𝟏 𝒓 𝟐 𝒏 𝟏 where 𝑪 𝟏 𝟏 𝒓 𝟏 𝒓  Example: Annuity Using the formula for geometric progressions we get: 𝟐 𝒏 𝟏 𝟏 𝒏 𝟏 𝒙𝒏 𝑪 𝟏 𝟏 𝒓 𝟏 𝒙 𝟏 𝒓 𝟏 𝟏 𝟏 𝒓 𝟏 𝒏 𝑪 𝟏 𝑪 𝟏 𝒏 𝟏 𝒓 𝟏 𝒓 𝟏 𝒓 𝟏 𝒓 𝟏 𝒓 𝟏 𝒓  Example: Perpetuity Annuity: security paying a constant cashflow C at the end of each periods forever Remember that the PV of annuity with n payments is: 𝑪 𝟏 𝒏 𝒓 𝟏 𝒓 Making n go to infinity that the PV of a perpetuity is: 𝑪 𝒓  Internal Rate of Return IRR is the cost of capital that forces NPV=0 NPV: n CFt IRR:  1  IRR t 0 Enter r, solve for NPV. t 0 Enter NPV=0, solve for IRR.  IRR Rationale IRR > Opportunity Cost of Capital Project’s rate of return is greater than its cost Extra return is left after repaying financing IRR > r : Accept IRR < r : Reject  Internal Rate of Return Example: project pay $1.1M in 1 year, requiring $1M of investment. In order to calculate IRR, find cost of capital that makes the project zero-NPV:  Internal Rate of Return Example 2: project pay $600K in 1 year and $600K in 2 years, requiring $1M of investment. In order to calculate IRR, find cost of capital that makes the project zero-NPV:  Internal Rate of Return Example 2: project pay $600K in 1 year and $600K in 2 years, requiring $1M of investment. Project NPV for different values of r 250000 200000 150000 100000 50000 0 0 5 10 15 20 25 30 -50000 -100000 -150000 -200000 -250000  Internal Rate of Return Example 2: project pay $600K in 1 year and $600K in 2 years, requiring $1M of investment. Project NPV for different values of r 250000 200000 150000 100000 50000 NPV>0 0 0 5 10 15 20 25 30 -50000 NPV