Capital Budgeting.ppt

Capital_BudgetingCapital Budgeting
Revision basic techniques
Compounding Discounting
FV = Future Value
PV = Present Value
r = rate
n = number of periods
Example
John deposits £200 in an account that pays 6% per year. At the end of 6 years what will he have?
Annuity
An equal sum of money (AMT) received or paid over a fixed period of time.
Compounding Discounting
Example: Annuity
Jill has been faithfully depositing $2,000 at the end of each year for the past 10 years into an account that pays 8% per year. How much money will she have accumulated in the account?
Example: Annuity
John wants to make sure that he has saved up enough money for college expenses: $40,000 per year for 4 years. How much money will John need to have accumulated in an account that earns 7% per year?
Perpetuity
A perpetuity is an equal sum of money (AMT), received or paid over an infinite period (will never cease).
Eg: You are considering the purchase of a bond that pays $60 per year forever, and the rate of interest you want to earn is 10% pa, what is the present value of the bond?
Capital Budgeting Decisions
Long-term decisions - go or no-go decision on a product, service, facility, or activity of the firm.
Involve longer time horizons
cost larger sums of money
require a lot more information to be collected . estimates of the timing and amount of cash flow
Models used have a pre-determined accept or reject criterion.
Methods
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Period
1. Net Present Value (NPV)
Discounts all the cash flows from a project back to time 0 using an appropriate discount rate, r:
A +NPV implies that the project is adding value to the firm’s bottom line, therefore, the higher the NPV the better.
RULE: Accept if NPV>0 reject if NPV<0