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CFS C8TX: Investment Decision Criteria (other investment criteria (d.…
CFS C8TX: Investment Decision Criteria
an overview of capital budgeting
a. Lessons from Disney theme park story
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
b. the typical capital-budgeting process
a. Phase I: the firm's management identifies promising investment opportunities
b. Phase II: Once an investment opportunity has been identified, its value-creating potential, what some refer to as its 'value proposition," is thoroughly evaluated
c. what are the sources of good investment projects?
d. types of capital investment projects
i. revenue enhancement investemnent
ii. cost-reduction investment
iii. mandatory investments that are a result of government mandates
net present value
a.why is NPV the right criterion?
b. calculating an investment's NPV
principle 1: money has a time value
principle 2: there is a risk-reward tradeoff
principle 3: cash flows are the source of value
NPV Decision Criterion: If the NPV is greater than zero, the project will add value and should be accepted, but if the NPV is negative, the project should be rejected. If the project's NPV is exactly zero (which is highly unlikely) the project will neither create nor destroy value
c. independent versus mutually exclusive investment projects
i. evaluating an independent investment opportunity
ii. evaluating mutually exclusive investment opportunities
substitutes
firm constraints
limited managerial time
limited financial capital
key term: capital rationing
iii. choosing between mutually exclusive investments when revenues remain the same
equivalent annual cost (EAC)
other investment criteria
a. profitability index
: is a cost-benefit ratio equal to the present value of an investment's future cash flows divided by its initial cost
PI decision criterion:
when the PI is greater than one, the NPV will be positive, so the project should be accepted. When the PI is less than one, which indicates a bad investment, NPV will be negative and the project should be rejected
b. Internal rate of return (IRR):
is analogous to the yield to maturity (YTM) on a bond.Specifically, the IRR is the discount rate that results in a zero NPV for the project
i. complications with IRR: Unconventional cash flows
ii. complications with IRR: multiple rates of return
iii. using the IRR with mutually exclusive investments
NPV profile
c. Modified Internal Rate of Return (MIRR):
to eliminate the problem of multiple IRRs. The idea behind the MIRR is to rearrange the project cash flows such that there is only one change in the sign of the cash flows over the life of the project
step 1:
modify the project cash flow stream by discounting the negative future cash flows back to the present using the required rate of return or discount rate that is used to calculate the project's NPV
step 2:
calculate the MIRR as the IRR of the modified cash flow stream
d. payback period:
the number of years needed to recover the initial cash outlay required to make the investment
payback decision criterion: accept the project if the payback period is less than a pre-specified maximum number of years
limitation #1: the payback period calculation ignores the time value of money, treating for example, cash flows three years from now the same as cash flows in one year
limitation #2: the payback period ignores cash flows that are generated by the project beyond the end of the payback period
limitation #3: there is no clear-cut way to define the cutoff criterion for the payback period that is tied to the value creation potential of the investment
e.discounted payback period:
to deal with the criticism that the payback period ignores the time value of money
discounted payback decision criterion: accept the project of its discounted payback period is less than the pre-specified number of years
f. summing up the alternative decision rules: 6 different rules including NPV to evaluate new investment alternatives
a glance at actual capital- budgeting practices
summary