Chapter 7 lecture outline (2)

Chapter 7: Net Prevent Value and Other Investment Rules 1) What is Capital Budgeting 2) Examples of Capital Budgeting Projects 3) Why is Capital Budgeting so Important 4) Classification of Capital Budgeting Projects 5) Classification of Capital Budgeting Projects by type of cash flow 6) The Six investment decision rules: The two most popular measures/rules used to evaluate a single capital project are net present value (NPV) and internal rate of return (IRR). But there are alternative methods that we should examine. These rules are used to evaluate the potential profitability of an investment or project.  The Payback Period (PbP)  The Discounted Payback Period (DPbP)  Net Present Value (NPV)  The Internal Rate of Return (IRR)  The Average Accounting Rate of Return (AAR) 1

The Yurdone Corp. wants to set up a private cemetery business. According to the CFO, Barry M Deep, business is looking up. As a result, the cemetery project will provide a net cash inflow of $115,000 for the firm the first year, and the cash flows are projected to grow at a rate of 6% per year, forever. The project requires an initial investment of $1,400,000. a. If Yurdone requires a 13% return on such undertakings, should the cemetery business be started? b. The company is somewhat unsure about the assumption of a 6% growth rate in its cash flows. At what constant growth rate would the company just break even if it still required a 13% return on investment? Practice problem 3: Calculate the IRR of a capital project with an initial investment of $30 million. The project generates after - tax cash flows of $10 million at the end of Year 1, $14 million at the end of Year 2, and $18 million at the end of Year 3. Determine whether the project should be undertaken given that the required rate of return is 10%. Practice problem 4: Let's consider two projects. project A & project B. The cash flow streams for both projects are given below. For both projects, the required rate of return is 7%. Find the NPV & IRR of each project. Year 0 1 2 3 NPV IRR A -$350,000 $425,00 0 $0 $0 B -$350,000 $16,000 $16,000 $466,000 The NPVs of the projects at the various discount rates are shown below: Discount rate% NPV (A) NPV(B) 0.000 75,000 148,000 5.000 54,762 82,299 7.000 47.196 59,323 8.715 40,930 40,930 10.000 36,364 27,881 12.960 26,239 0 3