Lesson #1 Capital Budgeting decisions are critical in defining a company’s business.

Lesson #2 Very large investments are frequently the result of many smaller investment decisions that define a business strategy.

Lesson #3 Successful investment choices lead to the development of managerial expertise and capabilities that influence the firm’s choice of future investments.

Typical Budgeting Process- Phase 1: the firm’s management identifies promising investment opportunities. Phase 2: once an investment opportunity has been identified, its value-creating potential, what some refer to as its “value proposition” is evaluated. Good investments are in are in markets with less competition. Revenue enhancement investment- entering a new market Cost-reduction investment- installing more efficient equipment, Mandatory investment- government regulated, safety material. NPV = PV of inflows – Cost= Net gain in wealth.. If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, accept S if mutually exclusive (NPVS > NPVL), and accept both if independent.

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Quiz

Internal rate of return, IRR, will increase as the required rate of return of a project is increased? False. If the project’s payback period is greater than or equal to zero, the project should always be accepted? False. When several sign reversals in the cash flow stream occur, the IRR equation can have more that one positive IRR? True. A new forklift under consideration by Home Warehouse requires an initial investment of 100,000 and produces annual cash flows of 50,000, 40,000, and 30,000. Which will not change if the required rate of return is increased from 10 to 12 percent? Internal rate of return. A machine cost 1,000 and has a 3 year life span and salvage value of 100. It will generate after-tax annual cash flow of 600/year, starting next year. If required rate of return is 10%, what is NPV? $570. Which are typical consequences of good capital budgeting decisions? All of the above. Errors in capital budgeting decisions? Decrease the firm’s value. Project Sigma requires an investment of 1 million and has NPV of 10. Delta requires an investment of 500,000 and has NPV of 150,000. The projects involve unrelated new product lines. Both projects should be accepted because they have positive NPV. WSU has various options for replacing a piece of manufacturing equipment. The present value of costs for option Ell is 84,000. Option Ell has a useful life of 5 years; annual operating costs were discounted at 9%. What is the equivalent annual cost? 21,595.77. With respect to the capital budgeting practices of large US companies: IRR and NPV have been gaining popularity. Suppose you determine that the NPV of a project is 1,525,855. What does that mean? The project would add value to the firm. Project H requires an initial investment of 100,000 and produces annual cash flows of 50,000, 40,000, and 30,000. Project T requires and initial investment of 100,000 and produces annual cash flows of 30,000, 40,000 and 50,000. If the required rate of return is greater than 0 and the projects are mutually exclusive: H will always be preferable to T. Project Black Swan requires an initial investment of 115,000. It has positive cash flows of 140,000 for each of the next two years. Because of major demolition and environmental clean-up costs, cash flow for the third and final year is (170,000) : This project might have more than one IRR.

CH. 14

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After-tax cost of debt = Yield (1-tax rate). NPV - PV(inflows) – Initial outlay – Floatation costs. Cost of equity = dividend yield + growth rate

Quiz

Valid issue in implementing the dividend growth model? The model is based upon the assumption that dividends are...