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Lecture 4

MGT 181 Lecture Notes - Lecture 4: Net Present Value, Decision Rule, Cash Flow


Department
Rady School of Management
Course Code
MGT 181
Professor
L Jean Dunn
Lecture
4

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October 13th, 2015
Good Decision Criteria: Capital Budgeting
→ We need to ask ourselves the following questions when evaluating capital
budgeting
decision rules:
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating a value for the
firm?
Net Present value is equal to the difference between the present value of a project’s expected
cash flow and its cost:
→ How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return from projects of this risk level.
The third step is to find the present value of the cash flows and subtract the initial
investment.
Net Present Value Decision Rule:
If the net present value is positive, accept the project.
A positive Net Present Value means that the is expected to add value to the firm and will
therefore increase the wealth of the owners.
Since our goals is to increase owner wealth, Net Present Value is a direct measure of how well
this project will meet our goal.
Decision Criteria Test - NPV
Does the NPV rule account for the time value of money?
Does the NPV rule account for the risk of the cash flows?
Does the NPV rule provide an indication about the increase in value?
Should we consider the NPV rule for our primary decision rule?
Payback: when evaluating a project the length of time it takes to get the initial cost back.
Computation:
Estimate the cash flow
Subtract the future cash flows from the initial cost until the initial investment has been
recovered.
Decision Rule - Accept if the payback period is less than some pre-established rule.
Does the payback rule account for the time value of money?
Does the payback rule account for the risk of the cash flows?
Does the payback rule provide an indication about the increase in value?
Should we consider the payback rule for our primary decision rule?
Payback:
Advantages: Easy to understand, adjusts for uncertainty of later cash flows, biased toward
liquidity.

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Disadvantages: Ignores the time value of money, requires an arbitrary cutoff point, ignores the
cash flows beyond the cutoff date, biased against long term projects such as research and
developments and new projects.
Internal rate of return: most important alternative to Net Present Value; often used in practice
and intuitively appealing; based entirely on the estimated cash flows and independent of interest
rates found elsewhere.
Internal rate of return is the discount rate that causes the NPV of the cash flows to equal zero.
Decision Rule: Accept the project if the Internal rate of return is greater than the required
return.
Advantages of internal rate of return: intuitively appealing; it is a simple way to communicate the
value of a project to someone who doesn’t know the details of the estimates; if the IRR is high
enough, you may not need to estimate a required return.
Net Present Value vs Internal Rate of Return
NPV and IRR will generally give us the same decision.
Exceptions: Non-conventional cash flows (with -/+ often changing)
Mutually exclusive projects (With initial investments and timing of cash flows
substantially different)
IRR and Non-conventional cash flows:
- When the cash flows change sign more than once, there is more than one IRR
- When you solve for IRR you are solving for the root of an equation and when you cross
the x-axis more than once, there will be more than one return that solved the equation
IRR and mutually exclusive projects: if you choose one you can't choose the other.
NPV directly measures the increase in value of the firm. Whenever there is a conflict between
NPV and another decision rule: always use NPV.
IRR is unreliable in non conventional cash flows and mutually exclusive projects.
The cash flows that should be included in a capital budgeting analysis are those that will only
occur if the project is accepted. These cash flows are called incremental cash flows.
The stand-alone principle allows us to analyze each project in isolation from the firm simply by
focusing on incremental cash flows.
Types of cash flows:
Sunk costs: costs that have accrued in the past.
Opportunity costs: costs of lost options
Positive side effects: benefits to other projects
Negative side effects: costs to other people
Changes in net working capital
Financing costs
Taxes
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