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Presentation1

  1. 1. GROUP 1
  2. 2. THE BASICTHE BASIC IDEAIDEA
  3. 3.  The difference between an investment’s marketThe difference between an investment’s market value and its costvalue and its cost  A measure of how much value is created or addedA measure of how much value is created or added today by undertaking an investmenttoday by undertaking an investment  Given our goal of creating value for the stockholders,Given our goal of creating value for the stockholders, the capital budgeting process can be viewed as athe capital budgeting process can be viewed as a search for investments with positive NPVsearch for investments with positive NPV NET PRESENT VALUE
  4. 4.  How much value is created from undertaking anHow much value is created from undertaking an investment?investment?  The first step is to estimate the expected future cashThe first step is to estimate the expected future cash flowflow  The second step is to estimate the requiredThe second step is to estimate the required return forreturn for projects of this risk levelprojects of this risk level  The third step is to find the present value of theThe third step is to find the present value of the cashcash flows and subtract the initial investmentsflows and subtract the initial investments
  5. 5. NPV – Decision RuleNPV – Decision Rule  If NPV is POSITIVE, ACCEPT the projectIf NPV is POSITIVE, ACCEPT the project  A positive NPV means that the project isA positive NPV means that the project is expected to add value to the firm and willexpected to add value to the firm and will therefore increase the wealth of the ownerstherefore increase the wealth of the owners  Since our goal is to increase owner wealth,Since our goal is to increase owner wealth, NPV is a direct measure of how well thisNPV is a direct measure of how well this project will meet our goalproject will meet our goal
  6. 6. Project ExampleProject Example InformationInformation Based on projected sales and costs, we expect that theBased on projected sales and costs, we expect that the cash flows over the five year life of the project will becash flows over the five year life of the project will be RM2000 in the first two years, RM4000 in the next twoRM2000 in the first two years, RM4000 in the next two years, and RM5000 in the last year. It will costs aboutyears, and RM5000 in the last year. It will costs about RM10000 to begin the production. We use a 10 percentRM10000 to begin the production. We use a 10 percent discount rate to evaluate new products. What should wediscount rate to evaluate new products. What should we do?do?
  7. 7. Computing NPV for theComputing NPV for the ProjectProject Using the formulas:Using the formulas: Present Value: (RM 2000/1.1) + (RM 2000/1.1)2Present Value: (RM 2000/1.1) + (RM 2000/1.1)2 + (RM 4000/1.1)3 + (RM 4000/1.1)4 + (RM+ (RM 4000/1.1)3 + (RM 4000/1.1)4 + (RM 5000/1.1)55000/1.1)5 =RM (1818+1653+3005+2732+3105)=RM (1818+1653+3005+2732+3105) =RM 12313=RM 12313 NPV : RM (12313-10000)=RM 2313NPV : RM (12313-10000)=RM 2313
  8. 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. 9. decision Rule Accept if the payback period is less than some preset limit.
  10. 10. THE PAYBACK RULETHE PAYBACK RULE • There are several disadvantages for the payback rule.There are several disadvantages for the payback rule. i.i. The time value of money is ignored.The time value of money is ignored. The payback period is calculated by simply adding upThe payback period is calculated by simply adding up the future cash flows.the future cash flows. • Analyzing the RuleAnalyzing the Rule No discounting involved.No discounting involved. ii.ii.Fails to consider any risk differences.Fails to consider any risk differences. iii.iii.Coming up with the right cutoff period.Coming up with the right cutoff period. No objective basis for choosing a particular year.No objective basis for choosing a particular year. No economic rationale for looking at payback.No economic rationale for looking at payback. No guide on how to pick the cutoff.No guide on how to pick the cutoff. Using a number that is chosen without any rationalUsing a number that is chosen without any rational reason.reason.
  11. 11. Redeeming Qualities Of The RuleRedeeming Qualities Of The Rule • The payback period rule is often used by largeThe payback period rule is often used by large companies when making minor decision.companies when making minor decision. • In addition to its simplicity, the payback ruleIn addition to its simplicity, the payback rule has two other positive features.has two other positive features.
  12. 12. • First, because it is biased toward short-termFirst, because it is biased toward short-term project, it is biased towards liquidity.project, it is biased towards liquidity. • Second, the cash flows that are expected toSecond, the cash flows that are expected to occur later in a project’s life are probably moreoccur later in a project’s life are probably more uncertain.uncertain.
  13. 13. THE PAYBACK RULETHE PAYBACK RULE AdvantagesAdvantages DisadvantagesDisadvantages  Easy to understand.Easy to understand.  Adjusts for uncertaintyAdjusts for uncertainty of later cash flows.of later cash flows.  Biased towardsBiased towards liquidity.liquidity. Ignores the time valueIgnores the time value of money.of money. Requires a cutoff pointRequires a cutoff point without any reason.without any reason. Ignores cash flowsIgnores cash flows beyond the cutoff date.beyond the cutoff date. Biased against long-Biased against long- term projects, such asterm projects, such as research andresearch and development, and newdevelopment, and new projects.projects.
  14. 14. THE PAYBACK RULETHE PAYBACK RULE • SummarySummary • Payback period is a kind of “break-even”Payback period is a kind of “break-even” measure.measure. Because time value is ignored.Because time value is ignored. Payback period as the length of time it takesPayback period as the length of time it takes to break even in an accounting sense, butto break even in an accounting sense, but not in an economic sense.not in an economic sense. Payback rule doesn’t ask the right question.Payback rule doesn’t ask the right question. Nevertheless, companies use it as a screenNevertheless, companies use it as a screen for dealing with a large number of minorfor dealing with a large number of minor investment decision that they have to makeinvestment decision that they have to make
  15. 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. 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. 17. adVantages and disadVantages of disCounted paybaCk ADVANTAGESADVANTAGES *INCLUDES TIME VALUE OF*INCLUDES TIME VALUE OF MONEYMONEY *EASY TO UNDERSTAND*EASY TO UNDERSTAND *DOES NOT ACCEPT NEGATIVE*DOES NOT ACCEPT NEGATIVE ESTIMATED NPVESTIMATED NPV INVESTMENTS WHEN ALLINVESTMENTS WHEN ALL FUTURE CASHFUTURE CASH FLOWS ARE POSITIVEFLOWS ARE POSITIVE *BIASED TOWARDS LIQUIDITY*BIASED TOWARDS LIQUIDITY DISADVANTAGESDISADVANTAGES *MAY REJECT POSITIVE NPV*MAY REJECT POSITIVE NPV INVESTMENTSINVESTMENTS *REQUIRES AN ARBITRAY*REQUIRES AN ARBITRAY CUTOFF POINTCUTOFF POINT *IGNORES CASH FLOWS*IGNORES CASH FLOWS BEYOND THE CUTOFF POINTBEYOND THE CUTOFF POINT *BAISED AGAINST LONG-TERM*BAISED AGAINST LONG-TERM PROJECTS, SUCH AS R&D ANDPROJECTS, SUCH AS R&D AND NEW PRODUCTS.NEW PRODUCTS.

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