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Chapter 10

# COMM-2016EL Chapter Notes - Chapter 10: Cost Of Capital, Net Present Value, Capital Budgeting

by Meghan Lever

Department

Commerce and AdministrationCourse Code

COMM-2016ELProfessor

Kayla LevesqueChapter

10This

**preview**shows pages 1-2. to view the full**7 pages of the document.**Chapter – Capital Budgeting Decisions

Capital-Budgeting Decisions – decisions made in the process of evaluating and choosing among long-term

capital projects

Capital budgeting has 3 phases:

1. Identifying potential investments

2. Selecting the investments to undertake (includes the gathering of data to aid in decision)

3. Follow-up monitoring or “post-audit” of investments

Managers use many different capital-budgeting models in selecting investments, and each model provides

unique information for a decision maker to choose among different investment proposals

Capital Investment Decisions

In planning and controlling, operations managers typically focus on a time-period…

Capital Assets – used to generate revenues or cost savings that affect more than one year’s financial results

• All capital outlays involve risk. The organization must commit funds to the project/program but cannot

be sure what – if any – returns this investment will yield later ...

• Well-managed organizations try to gather and quantify as many known or predictable factors as possible

before making a decision

There are 3 general types of capital-budgeting models: discounted-cash-flow models, payback models, and rate-

of-return models:

Discounted-Cash-Flow Models

Discounted-Cash-Flow (DCF) Model – a capital-budgeting model that focuses on cash inflows and outflows,

the time value of money, and identifying criteria for accepting or rejecting capital projects

MAJOR ASPECTS OF DCF

DCF models focus on expected cash inflows and outflows rather than on net income… Companies invest cash

today (cash outflow) to receive cash returns in future periods (cash inflow)

There are 2 main variations of DCF:

a) Net Present Value (NPV)

b) Internal Rate of Return (IRR)

Both variations are based on the theory of compound interest, demonstrated in table 1 & 2 in appendix B

NET PRESENT VALUE (NPV)

Net-Present-Value (NPV) Method – an investment evaluation technique that discounts all expected future

cash flows to the present using a minimum desired rate of return

• This minimum rate is often called the required rate of return (AKA. hurdle rate, or discount rate)

• The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the

higher the minimum desired rate of return

When choosing among several investments, the one with the greatest NPV, notwithstanding qualitative non-

financial considerations, is the most desirable

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Only pages 1-2 are available for preview. Some parts have been intentionally blurred.

The NPV method is applied as follows:

1. Prepare a list of all expected cash inflows and outflows, preferably in chronological order starting with the

initial investment at the time of the acquisition of the capital asset at time zero

2. Find the present value of each expected cash inflow and outflow

3. Total up the individual present values calculated in step 2. If the total is negative, reject the project; if it is

positive, accept the project

o A positive NPV means that accepting the project will increase the value of the firm because the

PV of the project’s cash inflows exceeds the PV of its cash outflows

o If NPV were 0, we would be indifferent

INTERNAL RATE OF RETURN (IRR)

Internal Rate of Return (IRR) – the discount rate that makes the net present value of the project equal to 0

• If the IRR is greater than the minimum desired rate of return, a project is to be accepted

• If the IRR is lower than the minimum desired rate of return, a project is to be rejected

The 3 steps in calculating IRR are:

1. Prepare a diagram of the expected cash inflows and outflows just like in calculating NPV

2. Find an interest rate that equates the present value of the cash inflows to the present value of the cash

outflows; that is, produces an NPV of 0

3. Compare the IRR with the minimum desired rate of return

If one outflow is followed by a series of equal inflows, you can use the following equation:

Initial Investment = Annual Cash Flow x Annuity PV Factor (F)

Not all IRR calculations work out exactly… To obtain a more accurate rate,

interpolation is needed

For example, let’s say F = 3.3750. In the table, the column closest to 3.3750 is

7%, which may be close enough for most purposes… The factor 3.3750 is

between the 7% factor and the 8% factor

ASSUMPTIONS OF DCF MODELS

Two major assumptions underlie DCF models…

➢ We assume a world of uncertainty. Therefore, we act as if the predicted cash inflows and outflows are

certain to occur at the times specified

➢ We assume perfect capital markets. That is, if we have extra cash at any time, we can borrow or lend

money at the same interest rate (this rate is our min. desired rate of return for NPV and IRR for IRR)

If these assumptions are met, no model could possibly be better than a DCF model. Unfortunately, our world

has neither certainty nor perfect capital markets. Therefore, NPV and IRR, although good, are not perfect

models. Nevertheless, the DCF model is usually preferred to other models

find more resources at oneclass.com

find more resources at oneclass.com

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