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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 17
Chapter Chapter 66
Capital Budgeting
Techniques
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 17
Net Present Value (NPV)
• Net Present Value (NPV). Net Present Value is
found by subtracting the present value of the after-tax
outflows from the present value of the after-tax
inflows.
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 17
Net Present Value (NPV)
• Net Present Value (NPV). Net Present Value is found
by subtracting the present value of the after-tax
outflows from the present value of the after-tax
inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, indifferent
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 17
Net Present Value (NPV)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 17
Using the Bennett Company data from Table
9.1, assume the firm has a 10% cost of capital.
Based on the given cash flows and cost of
capital (required return), the NPV can be
calculated as shown in Figure 9.2
Net Present Value (NPV)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 17
Net Present Value (NPV)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 17
• The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows with
the present value of the inflows.
• The IRR is the project’s intrinsic rate of return.
Internal Rate of Return (IRR)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 17
Advantages:• Cash flows rather than profits are analyzed• Recognizes the time value of money• Acceptance criterion is consistent with the goal of maximizing value
Disadvantage:• Detailed, accurate long-term forecasts are required to evaluate a project’s
acceptance
Capital Budgeting (NPV)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 17
• The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows with
the present value of the inflows.
• The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, indifferent
Internal Rate of Return (IRR)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 17
The Internal Rate of Return (IRR)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 17
Advantages:
• Cash flows rather than profits are analyzed
• Recognizes the time value of money
• Acceptance criterion is consistent with the goal of maximizing value
Disadvantages:
• Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance
• Difficult to solve for IRR without a financial calculator or spreadsheet
Capital Budgeting (IRR)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 17
• When NPV>0, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project.
• When IRR>k, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project.
• When NPV>0, IRR>k for a project—that is, if a project is acceptable using NPV, it is also acceptable using IRR
NPV versus IRR
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 17
Net Present Value Profiles
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 17
• Mutually exclusive projects– If you choose one, you can’t choose the other– Example: You can choose to attend graduate school next year at either
Harvard or Stanford, but not both• Intuitively you would use the following decision rules:
– NPV – choose the project with the higher NPV– IRR – choose the project with the higher IRR
IRR and Mutually Exclusive Projects
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 17
Example With Mutually Exclusive Projects
Period Project A
Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
The required return for both projects is 10%.
Which project should you accept and why?
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 17
-40,00
-20,00
0,00
20,00
40,00
60,00
80,00
100,00
120,00
140,00
160,00
0 0,05 0,1 0,15 0,2 0,25 0,3
Discount Rate
NP
V AB
NPV profiles
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 17
• NPV directly measures the increase in value to the firm• Whenever there is a conflict between NPV and another decision
rule, you should always use NPV• IRR is unreliable in the following situations
– Non-conventional cash flows– Mutually exclusive projects
Conflicts Between NPV and IRR