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Presentation1 Presentation Transcript

  • 1. GROUP 1
  • 2. THE BASIC IDEA
  • 3.
    • The difference between an investment’s market
    • value and its cost
    • A measure of how much value is created or added
    • today by undertaking an investment
    • Given our goal of creating value for the stockholders,
    • the capital budgeting process can be viewed as a
    • search for investments with positive NPV
    NET PRESENT VALUE
  • 4.
    • How much value is created from undertaking an
    • investment?
    • The first step is to estimate the expected future cash
        • flow
        • The second step is to estimate the required return for
        • projects of this risk level
        • The third step is to find the present value of the cash
        • flows and subtract the initial investments
  • 5. NPV – Decision Rule
    • If NPV is POSITIVE, ACCEPT the project
    • A positive NPV means that the project is
    • expected to add value to the firm and will
    • therefore increase the wealth of the owners
    • Since our goal is to increase owner wealth,
    • NPV is a direct measure of how well this
    • project will meet our goal
  • 6. Project Example Information Based on projected sales and costs, we expect that the cash flows over the five year life of the project will be RM2000 in the first two years, RM4000 in the next two years, and RM5000 in the last year. It will costs about RM10000 to begin the production. We use a 10 percent discount rate to evaluate new products. What should we do?
  • 7. Computing NPV for the Project Using the formulas: Present Value: (RM 2000/1.1) + (RM 2000/1.1)2 + (RM 4000/1.1)3 + (RM 4000/1.1)4 + (RM 5000/1.1)5 =RM (1818+1653+3005+2732+3105) =RM 12313 NPV : RM (12313-10000)=RM 2313
  • 8. Payback Rule
    • Payback period
    • The amount of time required for an investment
    • to generate cash flows sufficient to recover its
    • initial cost.
    • How long does it take to get the initial cost
    • back in a nominal sense.
  • 9.
    • Decision Rule
    • Accept if the payback period is less than some preset
    • limit.
  • 10. THE PAYBACK RULE
    • There are several disadvantages for the payback rule.
    • The time value of money is ignored.
    • The payback period is calculated by simply adding up the future cash flows.
    • Analyzing the Rule
    • No discounting involved.
    • Fails to consider any risk differences.
    • Coming up with the right cutoff period.
    • No objective basis for choosing a particular year.
    • No economic rationale for looking at payback.
    • No guide on how to pick the cutoff.
    • Using a number that is chosen without any rational reason.
  • 11. Redeeming Qualities Of The Rule
    • The payback period rule is often used by large companies when making minor decision.
    • In addition to its simplicity, the payback rule has two other positive features.
  • 12.
    • First, because it is biased toward short-term project, it is biased towards liquidity.
    • Second, the cash flows that are expected to occur later in a project’s life are probably more uncertain.
  • 13. THE PAYBACK RULE Advantages Disadvantages
    • Easy to understand.
    • Adjusts for uncertainty of later cash flows.
    • Biased towards liquidity.
    • Ignores the time value of money.
    • Requires a cutoff point without any reason.
    • Ignores cash flows beyond the cutoff date.
    • Biased against long-term projects, such as research and development, and new projects.
  • 14. THE PAYBACK RULE
    • Summary
    • Payback period is a kind of “break-even” measure.
    • Because time value is ignored.
    • Payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense.
    • Payback rule doesn’t ask the right question.
    • Nevertheless, companies use it as a screen for dealing with a large number of minor investment decision that they have to make because it is so simple.
  • 15. THE DISCOUNTED PAYBACK
    • The length of time until the sum of discounted cash
    • flows is equal to the initial investment.
    • The discounted payback rule would be :-
    • Based on the discounted payback rule, an
    • investment is acceptable if its discounted payback
    • is less than some prespecified number of years.
  • 16. Computing discounted payback for the project
    • Assume we will accept the project if it pays
    • back on a discounted basis in 2 years.
    • Compute the PV for each cash flow and
    • determine the payback period using discounted
    • cash flows
    • YEAR 1 : 165,000 – 63,120/1.12^1= 108,643
    • YEAR 2 : 108,643 – 70,800/1.12^2 = 52,202
    • YEAR 3 : 52,202 – 91,080/1.12^3 = -12,627
    • PROJECT PAY BACK IN YEAR 3
  • 17. ADVANTAGES AND DISADVANTAGES OF DISCOUNTED PAYBACK DISADVANTAGES *MAY REJECT POSITIVE NPV INVESTMENTS *REQUIRES AN ARBITRAY CUTOFF POINT *IGNORES CASH FLOWS BEYOND THE CUTOFF POINT *BAISED AGAINST LONG-TERM PROJECTS, SUCH AS R&D AND NEW PRODUCTS. ADVANTAGES *INCLUDES TIME VALUE OF MONEY *EASY TO UNDERSTAND *DOES NOT ACCEPT NEGATIVE ESTIMATED NPV INVESTMENTS WHEN ALL FUTURE CASH FLOWS ARE POSITIVE *BIASED TOWARDS LIQUIDITY