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Capital budgeting (Types of investment projects (Expansion, Replacement,…
Capital budgeting
Types of investment projects
Expansion
Replacement
Independent
Mutually exclusive
Divisible
Indivisible
Capital budgeting techniques
NPV
Sensitive to change in operating costs
IRR
Discount rate that causes PV of net future cash flows equal the cost of investment
IRR > WACC = accept
Payback method
Disadvantages
Not a profitability indicator
Ignores TVM
Bias against long term projects
Ignores cash flows after payback period
Advantages
Simple to calculate & understand
Widely used in practice
Risk indicator
ARR
Average incremental net income / Average investment
Ignores TVM
Perpetuates agency problem
Profitability Index
PV / I
Measures project's return in relation to cost
PI >1 = accept
Strategic perspectives
Rivalry among existing firms
Threat of substitute products
Threat of new entrants
Threat of barriers to entry
Bargaining powers of buyers/suppliers
Sensitivity analysis
Measures how a project's NPV & IRR changes if the value of any input variable is changed
Limitations
Assumes variables are independent
Indicates range of NPVs but does not indicate the probability of occurrence
Evaluation of risk is subjective
Capital rationing
Rank w/ profitability index
Projects w/ unequal lives
Equivalent annual costs
Inflation & nominal rate of return
Equivalent annual annuity = NPV / PV factor
Residual value = recoupment for tax purposes