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Business Investment Rules

6

Corporate Financial Management 2e Emery Finnerty Stowe
© Prentice Hall, 2004

Learning Objectives
Understand the practice of capital budgeting as it is practiced in most corporations. Understand how sound methods of evaluating business investments can be applied to both proposed projects and current operations.

Focus on Principles
Valuable Ideas
Look for new ideas to use as a basis for capital budgeting projects will create value Look for capital budgeting projects that will use the firm’s comparative advantage to create value.
Identify and estimate the expected future cash flows for a capital budget project on an incremental basis.

Comparative Advantage


Incremental benefits


Focus on Principles
Risk-Return Trade-Off
Incorporate the risk of a capital budgeting project into its cost of capital—the project’s required return. Measure the current value a capital budgeting project will create, its NPV.

Time-Value-Of-Money


Focus on Principles
Options


Recognize the value of options, such as the option to delay, expand, or abandon a project. Consider why the other party to a transaction is willing toparticipate. Consider the products and actions of competitors.

Two-Sided Transactions


Signaling


Chapter Outline
6.1 6.2 6.3 6.4 6.5 The Capital Budgeting Process Net Present Value Internal Rate of Return Using the NPV and IRR Criteria Other Widely Used Capital Budgeting Criteria 6.6 Business Investment in Practice

6.1 The Capital Budgeting Process
The process can be brokendown into five steps as a project moves from idea to reality: 1.Generating ideas for capital budgeting projects. 2.Reviewing existing projects and facilities. 3.Preparing proposals. 4.Evaluating proposed projects and creating the capital budget. 5.Preparing appropriation requests.

Generating ideas for capital budgeting projects
Division Management
ideas Research and Development ideas PlantManagement ideas Production Management ideas Strategic Planning

ideas

ideas

ideas

ideas

Classifying Capital Budgeting Projects
Maintenance Projects Cost Savings / Revenue Enhancement Capacity Expansions in Current Business New Products and New Businesses Projects Required by Government Regulation or Firm Policy

Preparing Proposals
Generally, the originator presents a writtenproposal. Most large firms use standard forms, and these are typically supplemented by written memoranda. There may be consulting studies prepared by outside experts.

Capital Budgeting and the Required Return
The required return is the minimum rate of return that you need to earn to be willing to make an investment. It is the rate of return that compensates you for the risk of the expectedfuture cash flows. It depends on the use of the money not the source.

6.2 Net Present Value
Recall that an asset’s net present value (NPV) is the difference between what it is worth and what it costs. The major difficulty of finding a project’s NPV rests with the need to see situations differently from other people in the market.

NPV example
Suppose you notice a run-down house for sale inyour neighborhood. The price is $80,000 as the house stands today. The house requires $40,000 worth of repairs. The repairs would take a year to complete. Fixed up, you could sell the house in one year for $135,000. Having a slightly better neighborhood increases the value of your own home by $5,000.

NPV example
If your discount rate is 10%, the net present value of the project to you is$7,273:

$140,000 NPV  $120,000  (1.10)
The net present value of the project to someone who does not live in the neighborhood is $2,727:

$135,000 NPV  $120,000  (1.10)

6.3 Internal Rate of Return
The internal rate of return is the discount rate that sets NPV of the expected cash flows to zero. The internal rate of return is the project’s expected return. Undertake a project if the IRR...
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