Professional Documents
Culture Documents
Finc5880 Lo Wk1
Finc5880 Lo Wk1
Finc5880 Lo Wk1
Dr. Ahmed
FINC 5880
Name__________
Investment Decisions
The purpose of capital budgeting analysis is to determine whether the project
is profitable based on todays dollar value. This approach is appropriate
because the projects costs and future cash flows price are spread over the
life of the project. To make a decision on whether to accept or reject a
project today, both costs and future cash flows must be in todays dollar
value.
Factors involved in Investment Decisions
Future Sales
Expected Cash Flows
Capital Expenditure
Timing
Cash Flows
Cash Outflows
Cash Inflows
Terminal Year Cash flows
Project Classifications
1. Replacement
2. Expansion
3. Safety /environment
4. Other
Investment Decision Rules
Payback Period
Payback period is the amount of time required to recover its initial
investment in a project. It ignores the time value of the money.
Net Present Value (NPV)
Net Present Value is the difference between the present value of the
cash inflows and the present value of the cash outflows.
>
<
>
<
>
<
0.00
0.00
RRR
RRR
1.00
1.00
Calculations
$200,000
$10,000
$30,000
$25,000
$5,000
4 years
$25,000
MACRS 3-year class
$250,000
$125,000
40%
10%
Year - 2
$250,000
($125,00)
$125,00
Year - 3
$250,000
($125,000)
$125,000
Time Line:
Payback Period:
Year Beginning balance Annual cash inflows Balance
0
($260,000)
0
($260,000)
1
Year - 4
$250,000
($125,000)
$125,000
2
3
4
Payback Period =
) =
years
Flexibility options
Five Procedures for Valuing Real Options
1.DCF analysis of expected cash flows, ignoring the option.
2.Qualitative assessment of the real options value.
3.Decision tree analysis.
4.Standard model for a corresponding financial option.
5.Financial engineering techniques.
Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-front
cost at t = 0 of $1,500. (All dollars in this problem are in thousands.) The projects
subsequent cash flows are critically dependent on whether a competitors product is
approved by the Food and Drug Administration. If the FDA rejects the competitive
product, NPCs product will have high sales and cash flows, but if the competitive
product is approved, that will negatively impact NPC. There is a 75% chance that the
competitive product will be rejected, in which case NPCs expected cash flows will be
$500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that
the competitors product will be approved, in which case the expected cash flows will be
only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure
one year from today whether the competitors product has been approved.
NPC is considering whether to make the investment today or to wait a year to find out
about the FDAs decision. If it waits a year, the projects up-front cost at t = 1 will
remain at $1,500, the subsequent cash flows will remain at $500 per year if the
competitors product is rejected and $25 per year if the alternative product is approved.
However, if NPC decides to wait, the subsequent cash flows will be received only for six
years (t = 2 ... 7).
Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before
proceeding, how much will this increase or decrease the projects expected NPV in
todays dollars (i.e., at t = 0), relative to the NPV if it proceeds today?
NPV
$934.21
-$1,378.29
$356.08
Squared dev.
NPVi E(NPV) Squared deviation
times probability
$578
$334,228
$250,671
-$1,734
$3,008,054
$752,013
Variance $1,002,685
Standard deviation
$1,001.34
CV
2.81
NPV
$616.03
$0.00
$462.02
Squared dev.
NPVi E(NPV) Squared deviation
times probability
$154
$23,718
$17,789
-$462
$213,463
$53,366
Variance
$71,154
Standard deviation
$266.75
CV
0.58
Reduction in the CV due to waiting
2.23