Capital Budgeting <ul><li>Time value of money is a fundamental concept.  If the interest rate in the economy is 10%, $1 to...
Capital Budgeting <ul><li>Now if I am to get $1.1 next year, $1.21 the year after and $1.331 the third year, what should I...
Capital Budgeting <ul><li>If someone wants to sell me this investment for $2.90, my NPV (net present value) of the project...
Capital Budgeting <ul><li>The basic equation of compound interest is shown on p. 96: </li></ul><ul><ul><li>PV(1+r) n  = FV...
Capital Budgeting <ul><li>To get the present value of a stream of cash outflows compute the sum of the deflated cash outfl...
Capital Budgeting <ul><li>To correctly compute project NPV: </li></ul><ul><ul><li>Use cash flows not accounting earnings. ...
Capital Budgeting <ul><li>Besides NPV, people also use  </li></ul><ul><ul><li>Payback period </li></ul></ul><ul><ul><ul><l...
Capital Budgeting <ul><li>Other measures: </li></ul><ul><ul><li>ROI (you know this) </li></ul></ul><ul><ul><li>IRR </li></...
Capital Budgeting <ul><li>Moral: </li></ul><ul><ul><li>Use NPV as the first step in evaluating projects. </li></ul></ul><u...
Upcoming SlideShare
Loading in …5
×

Merger and Acquisition -1

3,587 views

Published on

Merger and Acquisition

Published in: Economy & Finance, Business
  • Be the first to comment

Merger and Acquisition -1

  1. 1. Capital Budgeting <ul><li>Time value of money is a fundamental concept. If the interest rate in the economy is 10%, $1 today is worth $1.10 net year, $1.21 two years from today and $1.331 three years from today etc… </li></ul><ul><li>So, $1.10 next year $1.21 two years from now, $1.331 three years from now are all worth $1 today. </li></ul>
  2. 2. Capital Budgeting <ul><li>Now if I am to get $1.1 next year, $1.21 the year after and $1.331 the third year, what should I be willing to pay for the right to this stream of cash flows assuming that my only other alternative is to put the money in a bank account and get 10% interest? </li></ul><ul><li>Ans: $3, why? </li></ul><ul><ul><li>Each year’s cash inflow is worth a dollar today. </li></ul></ul>
  3. 3. Capital Budgeting <ul><li>If someone wants to sell me this investment for $2.90, my NPV (net present value) of the project is _____ </li></ul><ul><li>Ans: 10cents. How computed? </li></ul><ul><ul><li>The cash inflows are worth $3 in today’s dollars, the outflows are $2.90 in today’s dollars, so the NPV (always in current dollars) is Cash Inflows – Cash Outflows = $0.10. </li></ul></ul>
  4. 4. Capital Budgeting <ul><li>The basic equation of compound interest is shown on p. 96: </li></ul><ul><ul><li>PV(1+r) n = FV </li></ul></ul><ul><li>(1+r) n is called the “factor” </li></ul><ul><li>To get the present value of a stream of cash inflows divide each future inflow amount by the factor for that year (this is called deflating the FV) and add all the deflated inflows … this is the formula on </li></ul>
  5. 5. Capital Budgeting <ul><li>To get the present value of a stream of cash outflows compute the sum of the deflated cash outflows. </li></ul><ul><li>To compute NPV of a project subtract PV(outflows) from PV(Inflows). </li></ul><ul><li>To do the computations by hand you can use special formulas for perpetuities and annuities. We will ignore this. </li></ul><ul><li>For this course, you should know how to do the computations using a financial calculator. </li></ul>
  6. 6. Capital Budgeting <ul><li>To correctly compute project NPV: </li></ul><ul><ul><li>Use cash flows not accounting earnings. Remember to adjust for depreciation (and the tax consequences of depreciation) … </li></ul></ul><ul><ul><li>Exclude interest costs from relevant cash flows else you will be double-counting. </li></ul></ul><ul><ul><li>Include investment in working capital in funding requirements and discount the required additional investments at future points. </li></ul></ul><ul><ul><li>Include opportunity costs, ignore sunk costs. </li></ul></ul>
  7. 7. Capital Budgeting <ul><li>Besides NPV, people also use </li></ul><ul><ul><li>Payback period </li></ul></ul><ul><ul><ul><li>Time taken to earn back the original investment (there is no discounting of any cash flows in this method). </li></ul></ul></ul><ul><ul><ul><li>This method may be useful when long-term cash flows are uncertain. However it can lead to serious mistakes in project selection since it ignores the “tail” of cash flows beyond the recovery of the initial amount. </li></ul></ul></ul><ul><ul><ul><li>In effect this method is very conservative and not a good first choice to use. </li></ul></ul></ul>
  8. 8. Capital Budgeting <ul><li>Other measures: </li></ul><ul><ul><li>ROI (you know this) </li></ul></ul><ul><ul><li>IRR </li></ul></ul><ul><ul><ul><li>The discount rate that makes the NPV of the project zero. You can compute this on any financial calculator. </li></ul></ul></ul><ul><ul><ul><li>There may be multiple IRRs for a single project, so this method can produce confusing answers. </li></ul></ul></ul><ul><ul><ul><li>IRR may be used to prioritize among projects when capital is limited: select projects with the highest IRR till you have used up all your capital. </li></ul></ul></ul><ul><ul><ul><li>However, this rule can be seriously misleading as well since it assumes that all cash inflows can be invested at the project’s internal rate of return which is an unrealistic assumption. </li></ul></ul></ul>
  9. 9. Capital Budgeting <ul><li>Moral: </li></ul><ul><ul><li>Use NPV as the first step in evaluating projects. </li></ul></ul><ul><ul><li>If capital is in short supply, try and find the best mix of projects to take using simulation rather than use some arbitrary short-cuts (IRR etc.). </li></ul></ul><ul><ul><li>Look at payback period as a second step, especially if the projects are otherwise comparable (in magnitude of investment, life of cash flows). If strategic flexibility in the firm’s investment base matters, payback period is a healthy tool in spite of serious theoretical deficiencies. </li></ul></ul><ul><ul><li>In other words, be careful of using only NPV because cash flows in the far future are hard to predict. </li></ul></ul>

×