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Feb. 15

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  • discounted at the project’s cost of capital. Any project with a positive NPV is a possibility. Actually, theory says that any time you are confronted with a project offering positive NPV, you should grab it, as long as that project does not preclude a more attractive option. There are two further considerations, of course: delayability and irreversibility. If a project is a now or never choice and NPV is positive or if it can be costlessly undone down the road, you should invest now. If not, you should consider the value of retaining the option of investing later. NPV is simple to use even for those who might not be so good with numbers. Interesting observation; how come critic of continuous budgeting in public sector claim it is too hard for politicians to understand?
  • Management can only handle so many projects Liquidity and solvency constraints.
  • Makes us aware of our ignorance or uncertainty and the need to take it into consideration. Getting your cash flows right are the most important problem in capital budgeting. What some of the states of nature might be…..best case or lucky, moderately lucky, we go down in flames… Not a lot of difference between foreign and domestic but with domestic you have less variables. The more projects the more likely your cost of capital will go up….banks will often notice that you are over stretched before you do.
  • When Honda introduced Acura some customers switched from Honda to Acura
  • Example: Suppose IBM decides to build a new office building in Sao Paulo on land it bought 10 years ago. IBM must include the cost of the land in calculating the value of undertaking the project based on the current market value of the land, not the price it paid 10 years ago. Example: Ford raises the price of engines from the U.S. plant it increases profitability of the engine plant. But when it sells the engines to its English affiliate, the English affiliate’s profits decline. Move to opportunity cost slide!!!
  • Examples: GM small cars Kodak – Film Zenith – Televisions They thought overseas expansion was too risky or unattractive and the next thing they knew their domestic position was eroding.
  • Example: Investing in Japan makes you tough. Don’t leave intangibles out of the analysis, either up or down, but if they matter the right number is not 0. Accountants do this a lot and should be flogged for this mistake.
  • Problems that domestic firms do not have to worry about: Differences between local branch or subsidiary and parent company cash flows, foreign tax regulations, expropriation, blocked funds, exchange rate and inflation Project-specific financing and differences between the basic business risks of foreign and domestic projects.
  • Standpoint of sub means local cost of capital
  • Standpoint of sub means local cost of capital
  • Do political risks violate assumption of ergodicity? Can you diversify them away? Buy insurance?
  • Ri = nominal return on risk free asset Rm = return on market portfolio COC = .03 + 1(.09-.03.) = .09 COC = .03 + 1.5(.09-.03.) = .12 COC = .03 + .5(.09-.03.) = .06
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