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II.
Capital Budgeting and Financial Decision-making: The Capital Budgeting Decision-making Criteria
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An Introduction to Finance
What is finance?
Finance is the study of the art and the science of money
management; it is based on the Latin root finis, meaning the end. In managing ours or our firms money, we consider historical outcomes or endings, and we propose future results as a function of decisions made today. Those outcomes or results are typically portrayed using financial statements.
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I.
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With the making of this decision, we consider three features of the cash flows deriving from the decision:
The size of the cash flows
The timing of the cash flows The risk of the cash flows
We review a couple examples of capital budgeting decisions.
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The loss of control and reduced potential cash flows to the founders with an equity or stock sale
We expand our review with a few capital structure decisions.
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II.
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As well, problems 18-22 in your BA II Plus Review Sheet on pages 28 and 29 of your course packet will assist you. Those problems introduce us to the ideas below.
First, the NPV rule (pages 224-228) The NPV = PV (Inflows) PV (Outflows or Cost)
We accept deals where the NPV > 0, and We reject deals where the NPV < 0. We illustrate all these new rules by example
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But, what if our time value of money (or required return, in this case) is greater than 8%? Or the cash flows are irregular? Then what?
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The IRR is that discount rate that forces the NPV to zero. With equal-sized cash flows or annuities, the IRR is simply the I/Y. With irregular cash flows, we must use the CF keys to discover the IRR. We know the IRR in the first example with even $35,000 annual cash flows for 8 years is over 8%, as our NPV > 0. If the IRR > Required Return, then the NPV must be > 0.
A graphical illustration, as on page 236 of your text, illustrates this premise. Using the CF keys, IRR = 8.149% in the first example, as also I/Y = 8.149%. With irregular cash flows, the IRR changes, but with a changing required return, the IRR is unchanged. The IRR is not impacted by the required return!
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NPV
30,000 20,000 10,000 0 -10,000 0 -20,000 Discount Rate 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
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PI = PV (Inflows)/PV (Outflows)
The PI is larger the greater a projects IRR. For the original set of cash flows, at a discount rate of 8%, the PV of the health plans cash flows (the numerator of the PI function above) was just over $201,000. (Cost plus the NPV). The cost or denominator was $200,000. The PI is around 1.006. ($201,132/$200,000) The PI reveals a projects bang for the buck. If we cannot do all positive NPV deals, we rank them by PI, and invest in them til we are out of money. That maximizes the total possible NPV out of a given pot of invest-able capital.
The four new rules are used in concert, by the firm and its financial managers, to optimize the results of the capital budgeting decision-making process.
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