GOAL OF THE FIRM: MAXIMIZE THE WELTH OF ITS CURRENT SHAREHOLDERS

This is called the NPV

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Basically, NPV = 0
For the case IRR(S) = 14.5% and IRR(L) = 11.8%

NPV Profile: The plot of a project’s NPV against the Cost-Of-Capital is defined as the NPV.
The value of early cash flows depends on the rate at which we can reinvest them. NPV method
assumes that we can reinvest at the cost of capital itself. IRR assumes that we can reinvest at
the IRR.

The best assumption is reinvestment @ COC and therefore NPV is better. So, whenever we
evaluate mutually exclusive projects especially the ones which differ in scale and/or timing, we
should choose the NPV method.
This corrects the first flaw of the Payback period but it also fails to consider the other ones.
CAPITAL RATIONING is a situation in which a firm limits its capital expenditure to less than the
amount required to fund the optimal capital budget. Why do they do this?
1. Reluctance to issue new stock
- Floatation costs can be very high
- Investors might perceive it as a signal that the firm’s equity is overvalues
- Might have to reveal sensitive data to investors

Will be better to explicitly incorporate the cost of raising capital into the company’s cost of capital
and then use NPV.

2. Constraints on non monetary resources

Better solution is use linear programming to assign scarce resources.

3. Controlling estimation bias

Better solution is to implement a post audit program and to link the accuracy of forecasts to the
compensation of the managers.

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Issues in Project Analysis
1. Purchase of Fixed Assets and Noncash Charges

2. Changes in Net Operating Working Capital

3. Interest Expenses are Not included in the Project Cash Flows

4. Sunk Costs
5. Opportunity Costs

6. Effects on Other Parts of the firm : EXTERNALITIES

Also talk about environmental externalities like pollution etc.

7. Replacement Projects
 8. Timing of Cash Flows

** INFLATION INDUCED BIAS?**

RISK ANALYSIS

- Sensitivity Analysis
- NPV break even Analysis
- Scenario Analysis
DECISION TREES - RISK MANAGEMENT

Decision trees can be used to evaluate multi stage decisions

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