This document discusses firm investment decisions and capital budgeting. It covers classifying projects, using the net present value (NPV) rule to evaluate projects, calculating cash flows and discount rates, and using the internal rate of return as an investment criterion. The objective is to increase the firm's current market value by taking projects with a positive NPV.
This document discusses firm investment decisions and capital budgeting. It covers classifying projects, using the net present value (NPV) rule to evaluate projects, calculating cash flows and discount rates, and using the internal rate of return as an investment criterion. The objective is to increase the firm's current market value by taking projects with a positive NPV.
This document discusses firm investment decisions and capital budgeting. It covers classifying projects, using the net present value (NPV) rule to evaluate projects, calculating cash flows and discount rates, and using the internal rate of return as an investment criterion. The objective is to increase the firm's current market value by taking projects with a positive NPV.
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
capital budgeting decisions
Capital budgeting decisions refer to financial decisions
regarding the use of a company’s scarce resources in making capital investments. Routine vs Strategic capital budgeting decisions Projects with different degree of irreversibility.
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
Classification of investment projects
Classification according to economic life: Short-term
Investment and Long-term Investment. Classification according to Risk of Returns: New products and markets, replacement projects, expansion projects, and mandated projects. Classification according to Dependence on other projects: independent, mutually exclusive, contingent, and complementary projects.
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
NPV Rule
Objective: Increase Firms Current Market Value
Implication: take projects with positive NPV. Project has cash flows of:
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
Example of NPV: An investment outlay of $10 million with
10% RRR
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
Example of NPV: Investment Decisions
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
The Investment Profile
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
Investment Criteria: Internal Rate of Return
For a single project, take it if and only if its NPV is positive
For many independent projects, take all those with positive NPV For mutually exclusive projects, take the one with positive and highest NPV
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
Cash Flow Calculations: Main points
Use cash flows, not accounting earnings
Use after-tax cashflows Use cash flows attributable to the project (compare firm value with and without the project): Forget sunk costs: bygones are bygones Include investment in working capital as capital expenditure Include opportunity costs of using existing equipment, facilities, etc. Correct for biases from fighting for resources inside firm
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Firm Investment decisions
Discount rate
A project’s discount rate (i.e., required rate of return) is the
expected rate of return demanded by investors for the project The discount rate(s) in general depend on the timing and risk of the cashflow(s) The discount rate is usually different for different projects Therefore, it is in general incorrect to use a company-wide cost of capitalto discount cash flows of all projects
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021