25300 Lecture Notes - Lecture 5: Capital Market, Net Present Value
Capital Budgeting
• Capital Budgeting Process
→ Success of a business depends on the investment decisions made
today
→ Investment decision: must make financially sensible choices
→ Future growth relies on good projects (allocating scare
resources)
→ Investment should be worth more than it costs (cost-benefit
analysis)
1. Generation of proposals
2. Evaluation/Selection of capital projects (forecasts & timing of
CF’s)
Should provide a return at least equal to that required by
investors
3. Approval & Implementation 4. Monitoring
* Most important step is estimation of future cash flows (size)
* Also, expected cost of investment and amount of risk inherent in
project
• Net Present Value (size, timing, risk)
→ NPV = market value–initial investment = change in shareholder
wealth
→ If NPV is positive, we accept the investment (aka DCF valuation)
→ CFt / (1 + r)^t – lo (*lo = investment in time 0)
• Internal Rate of Return (required rate of return that gives a zero
NPV)
→ If IRR > discount rate (same as required return) = we accept
→ IRR is % figure, NPV= $ (only NPV will always max shareholder
wealth)
→ IRR can lead to faulty decisions if two projects are mutually
exclusive
• Payback Period (ignores TVM)
→ Most frequently used (Shorter payback = less risky)
→ Investment is accepted if payback period < pre-specified no. of
years
→Disadvantage: bias towards ST investments (measures liquidity)
→ Focus should be on impact on share value, not time to recover
costs
• Discounted Payback Period (cash flows converted to PV)
Document Summary
Success of a business depends on the investment decisions made today. Investment decision: must make financially sensible choices. Future growth relies on good projects (allocating scare resources) Investment should be worth more than it costs (cost-benefit analysis: generation of proposals, evaluation/selection of capital projects (forecasts & timing of. Should provide a return at least equal to that required by investors: approval & implementation 4. * most important step is estimation of future cash flows (size) * also, expected cost of investment and amount of risk inherent in project. Npv = market value initial investment = change in shareholder. Cft / (1 + r)^t lo (*lo = investment in time 0) wealth. If npv is positive, we accept the investment (aka dcf valuation: net present value (size, timing, risk, internal rate of return (required rate of return that gives a zero. If irr > discount rate (same as required return) = we accept.
