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Chapter

Capital Budgeting

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Net Present Value

Net Present Value - Present value of cash

flows minus initial investments.

Opportunity Cost of Capital - Expected rate

of return given up by investing in a project

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Net Present Value

NPV = PV of all cash inflows - initial

investment

NPVC C

r

t

t

0 1( )

NPVCC

r

C

r

t

t

01

1

2

21 1 1( )( )...

(

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Net Present Value

Terminology

C = Cash Flow and C0= Initial Investment

t = time period of the investmentr = opportunity cost of capital

The Cash Flow could be positive or negative at

any time period.

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Net Present Value

Net Present Value Rule

Managers increase shareholders wealth by

accepting all projects that are worth more

than they cost.

Therefore, they should accept all projects

with a positive net present value.

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Other Investment Criteria

Internal Rate of Return (IRR)- Discount rate at

which NPV = 0.

IRR is the discount rate that makes your NPV

equals to zero thus have the following relationshiphold:

PV (inflows) = PV (Outflow)

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Internal Rate of Return

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Discounted Payback Period

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Discounted Payback Period

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Profitability Index

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Profitability Index

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Profitability Index

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1) Johnnys Lunches is considering purchasing a new, energy-efficientgrill. The grill will cost $20,000 and will be depreciated according tothe 3-year Straight line method. It will be sold for scrap metal after 3years for $5,000. The grill will have no effect on revenues but will saveJohnnys $10,000 in energy expenses. The tax rate is 35 percent.

a. What are the operating cash flows in Years 13?b. If the discount rate is 12 percent, should the grill be purchased?

2) Bottoms Up Diaper Service is considering the purchase of a newindustrial washer. It can purchase the washer for $6,000 and sell its oldwasher for $2,000. The new washer will last for 6 years and save $1,500 a

year in expenses. The opportunity cost of capital is 15 percent, and thefirms tax rate is 40 percent.a. If the firm uses straight-line depreciation to an assumed salvage valueof zero over a 6-year life, what are the cash flows of the project in Years06? The new washer will in fact have zero salvage value after 6 years,and the old washer is fully depreciated.b. What is project NPV?

Problems