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Lecture 1:

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Capital budgeting deals with the analysis of PV of annuity due C


capital expenditures (investments) that are

expected to generate cash flows beyond the

first year. Capital budgeting decision is the
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FV of annuity due C

allocation of funds among alternative


investment opportunities in such a way that

shareholder wealth is increased.


Objective: maximize the market value of

the firm's common stock and, the wealth
of its shareholders.

Shareholders provide the risk capital that acts

as a shock absorber to cushion the claims of
other stakeholders.
Value gap the difference between the value
of the company if it were optimally managed
and the actual value of the company.
Accounting profits are of no value to investors:
they can be manipulated by managers for
reporting purposes
Lecture 2:
The value on project: It must focus on
cash and only cash, It must account for
the time value of money, It must account
for risk. Cash is a limited and controlled
resource, Those controlling the resource can
charge for its use, The longer the period of use
the higher the interest for the use of the cash.
The first basic principle of finance is that a
dollar today is worth more than a dollar
Perpetuity is an asset that pays a fixed cash
flow at regular intervals forever. Annuity is an
asset that pays a fixed cash flow at regular
intervals for a specified number of periods.

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PV of annuity C

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Inflation - Rate at which prices as a whole are

increasing. Nominal Interest Rate - Rate at
which money invested grows. Real Interest
Rate - Rate at which the purchasing power of an
investment increases.
Lecture 3:
Net working capital.: money that firm must
invest in accounts receivable, inventory, and
cash to support the sales and production of its
products and services. Initial investment in
working capital must be recovered at the
termination of the project.
Net cash flow is usually calculated as profit
after tax, plus depreciation and other non-cash
charges, minus (plus) any additions to (recovery
of) working capital during the period, and minus
(plus) capital expenditures (sales of fixed
assets) during the period. This measure includes
all project cash inflows and outflows and ignores
non-cash items. Depreciation is added back to
net income because it is a non-cash item.
Net CF = (Revenues Costs
Depreciation)x(1 T) + Depreciation
NWC CapEx,
NPV Strength: consistent with shareholder
wealth maximization. Value additivity principle.
NPV weakness: hard time understanding the
Non-DCF methods: Payback, (riskier, shorter),

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DCF methods: Discounted Payback, IRR, MIRR,


FV of annuity C

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PV of growing annuity C1


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Payback strength: easy and simple. Payback

weakness: ignore time value of money (fixed
by discount PP) and CF beyond payback period.
Account RoR: ratio of average after tax profit
to average book investment. (Revenues Costs
Depreciation)x(1 T). ARR strength: simple,

target rate of return.(greater accept).MIRR

ARR strength: solve borrow lend problem;
weakness: ignore time value of money;
multiple IRR; mutual exclusive project
on accounting income instead of CF. (but cannot fix scale diff).
IRR: exceed cost of capital acceptProfitability
Index (PI), also known as the
its yield more than its cost of capital benefit-cost
positive ratio, is the present value of future
cash flows divided by the initial cash
IRR strength: rate of return easier to
understand than DCF.
Capital rationing is a situation when firms
constrain the size of their capital budgets.
IRR weakness: dont differentiate between
Capital rationing may be self-imposed or
lending and borrowing; multiple rate of return;
externally imposed.
mutually exclusive projects.
NPV and IRR give conflicting results when
discount rate is less than the crossover rate
rate at which NPVs of mutually exclusive
projects are equal. Or when the mutually
exclusive projects are substantially different (i)
in the timing of cash flows or (ii) in scale.

3(i). Timing of Cash Flows

The conflict in the IRR and NPV rankings of
projects A and B arises because of differences
in the timing of their cash flows, with most of
As cash flows arriving in the early years and
most of Bs cash flows arriving in the later
The reason for conflicting rankings is that IRR
implicitly assumes that intermediate cash flows
occurring during the life of the project can be
reinvested at a rate equal to IRR, whereas NPV
implicitly assumes a reinvestment rate equal to
the projects cost of capital.
In such cases always trust NPV as it more
realistically represents the opportunity cost of
(ii). Scale Differences. This is because NPV
takes into account the size differences in initial
investment while IRR does not. NPV rule in this
case is correct, assuming there is no capital
MIRR is a discount rate at which the present
value of a projects annual cash outflows is
equal the present value of its terminal value,
where the terminal value is found as the sum of
the future values of the cash inflows,
compounded at the firms opportunity cost of

Lecture 4

Three major types of cash flows must be

Initial investment outlay
Net cash flows during the life of the
The terminal or ending value of the
What matters to investors is not projects
total cash flow per period but rather the
incremental cash flows generated by the
project relative to the additional dollars they
must invest today.
The incremental cash flows for project
evaluation consist of any and all changes in
the firms future cash flows that are a direct
consequence of taking the project. Any cash
flow that exists regardless of whether or not
a project is undertaken is not relevant.
A firm evaluating a new project can estimate
its incremental cash flows as: Firms total
cash flows with project Firms total cash
flows without project.
Cannibalization or erosion, when a new
product takes sales away from the firms
existing products
If the lost sales would have been lost
anyways even if product B were not
introduced, then these lost sales should not
enter incremental cash flow analysis and
should not be counted as a consequence of
Synergy: creates additional sales for
other products, opposite of cannibalization.
In calculating the projects cash flows, the
additional sales and associated incremental
cash flows should be attributed to the
Project costs must include the true economic
cost of any resource required for the project,
regardless whether the firm already owns the
resource or has to go and buy it.
Opportunity cost, the cash the asset could
generate for the firm should it be sold or put
to some other use.
Sunk cost represents past expenditures on
a project, and they should not affect the
decision today whether to continue or
terminate the project.

Transfer prices: The prices at which goods

and services are traded within a company,
often used to to reduce taxes.
New products and lines have to be
introduced without fear of cannibalization. In
a competitive market, the rule is simple: If
you must be a victim of a cannibal,
make sure the cannibal is a member of
your family!
Depreciation itself is a non-cash expense; thus, it
is only relevant because it affects taxes.
Straight-line depreciation: DEP = (Initial cost
salvage) / number of years, Very few assets are
depreciated straight-line for tax purposes.
Accelerated depreciation (MACRS): Need to
know which asset class is appropriate for tax
purposes, Multiply percentage given in table by
the initial cost, Depreciate to zero, Mid-year
convention. better than straight line
because large CF in early greater NPV
NWC invested in the early years of project life
must be recovered in the later years of project
Inflation: neutral effect on NPV. Overstate
the taxable income, negative effect, PV get
Contractual: unaffected by inflation. These are,
for example, commitments such as debt, longterm leases, labor contracts, rents, and most
importantly depreciation.
Non-contractual cash flows fluctuate in line with
changing market conditions. Most of firms
revenues and costs are non-contractual in nature.
Book value wont be affected by inflation. This is
because the tax system taxes nominal income
rather than real income. Profit gets overstated
sonic since the true amount of depreciation is
Multinational corporations (MNC) find various
complications when evaluating foreign
investments. Among these complications are:
Differences between project and parent
company cash flows
Foreign tax regulations
Exchange rate changes and inflation
Differences in business risk of foreign and
domestic projects

The analysis of a foreign project raises two

Converting nominal foreign currency
additional issues:
cash flows into nominal home currency terms
using forward exchange rates, then
Should cash flows be measured from the
discounting those nominal cash flows at the
viewpoint of the project or that of a parent?
nominal domestic required rate of return.
Should the additional economic and political
Or discounting the nominal foreign
risks that are uniquely foreign be reflected in
currency cash flows at the nominal foreign
cash flows or discount rates?

required rate of return, then
Economic theory suggests that the value
of a
the resulting foreign currency
project is the net present value of future
present value into the home currency present
flows back to the investor.
value using the current (spot) exchange rate.
A three-stage approach can be employed for
Interest rate parity theory
project evaluations:

Purchasing power parity

Project cash flows are calculated from
the projects standpoint as if it were a
Expectation theory of exchange rates
separate entity.
Forecast amounts, timing, and formInternational
Fisher effect
transfers to parent company, taking into

account taxes and other expenses that will be

Exchange rate risk: Transaction exposure is
incurred in the transfer process.
the sensitivity of the firms contractual

The parent MNC must take into

transactions in foreign currencies to exchange rate
account indirect costs and benefits that the movements.reduced by using various financial
project will confer on the rest of the company,
instruments, such as currency forward or future.
such as increase or decrease in export sales Economic exposure is the sensitivity of the
by another subsidiary.
firms cash flows to exchange rate movements.
Translation exposure is the exposure of the
True profitability of the project must be
multinational firms consolidated financial
estimated by
statements to exchange rate fluctuations.

Adjusting for the effects of transfer

pricing and fees and royalties,

Adjusting for global cost/benefits that

are not reflected in the projects financial
The present value of future cash flows: