Beruflich Dokumente
Kultur Dokumente
Philip M. Tsar
(Petroleum Engineer National Oil Corporation - Kenya)
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Scope
Capital Budgeting Decision Criteria
Net Present Value (NPV), Real and nominal NPVs, Internal rate of return (IRR), Problems with IRR, Payback, Capital productivity index (CPI), Example economic evaluations
The Net Present Value (NPV) of a project is the present value of all the after tax cash flows connected with the project All its cost and revenues, now and in the future
Where: CF0 = $-63.6 MM; n = 10; CFAT = $11 MM, Net Salvage Value = $ 7.7 MM
Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10%
Revenues Expenses
Cash flow
$2,000 1,000
$1,000
Cash flow
$1,100.00 $500 x +454.55 +826.45 +$181.00 NPV 1 1.10
$500
$1,000 x
1 1.10 2
Real: Projects cost and revenues, now and in the future pre-inflation/ uninflated i.e. real sums
Nominal: Projects cost and revenues, now and in the future postinflation/inflated i.e. money of the day
Why does the NPV rule work? And what does work mean? Look at it this way:
A firm is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service; The market value of the firm is based on the present value of the cash flows it is expected to generate; Additional investments are good if the present value of the incremental expected cash flows exceeds their cost;
Thus, good projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs!
Moral of the story: Invest only in projects with positive NPVs.
Some specific benefits and costs of each method of production sharing are outlined below (in addition to those listed on the previous slide):
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Sales Costs Gross profit Depreciation Earnings before taxes Taxes (25%) Net income
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Average book value: Initial investment = $240 Average investment = ($240 + 0)/2 = $120
AAR =
$45 $120
= 37.5%
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To confirm the IRR exceeds the projects cost of capital Does the expected rate of return on the investment exceed the required rate of return? Will it create value?
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Whats the IRR? Find the rate at which the computed NPV = 0:
at 25.00%: NPV = _______
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Whats the IRR? Find the rate at which the computed NPV = 0: at 25.00%: NPV = at 33.33%: NPV = at 42.86%: NPV = at 66.67%: NPV = 0 0 0 0
Two questions: 1. Whats going on here? 2. How many IRRs can there be?
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Now lets go back to the initial example - we assumed the following information on Project X: Initial outlay -$1,100 Required return = 10% Annual cash benefits: Year Cash flows
1 2
$ 500 1,000
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Thank you!!
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