1858 Words8 Pages

INTRODUCTION TO
CAPITAL BUDGETING
Overview 159
7.1 The NPV Rule for Judging Investments and Projects 159
7.2 The IRR Rule for Judging Investments 161
7.3 NPV or IRR, Which to Use? 162
7.4 The “Yes–No” Criterion: When Do IRR and NPV Give the Same Answer? 163
7.5 Do NPV and IRR Produce the Same Project
Rankings? 164
7.6 Capital Budgeting Principle: Ignore Sunk Costs and
Consider Only Marginal Cash Flows 168
7.7 Capital Budgeting Principle: Don’t Forget the Effects of Taxes—Sally and Dave’s Condo Investment 169
7.8 Capital Budgeting and Salvage Values 176
7.9 Capital Budgeting Principle: Don’t Forget the Cost of Foregone Opportunities 180
7.10 In-House Copying or Outsourcing? A Mini-case
Illustrating Foregone Opportunity*…show more content…*

Thus, if we have correctly chosen the discount rate r for the project, the PV is what we ought to be able to sell the project for in the market.1 The net present value is the wealth increment produced by the project, so that NPV 0 means that a project adds to our wealth: NPV = CF0 ↑ Initial cash flowrequired to implement the project. This is usually a negative number. + N t=1 CFt (1 + r )t ↑ Market value of future cash flows. An Initial Example To set the stage, let’s assume that you’re trying to decide whether to undertake one of two projects. Project A involves buying expensive machinery that produces a better product at a lower cost. The machines for project A cost $1,000 and, if purchased, you anticipate that the project will produce cash flows of $500 per year for the next five years. Project B’s machines are cheaper, costing $800, but they produce smaller annual cash flows of $420 per year for the next five years. We’ll assume that the correct discount rate is 12%. 160 PART TWO CAPITAL BUDGETING AND VALUATION 1This assumes that the discount rate is “correctly chosen,” by which we mean that it is appropriate to the riskiness of the project’s cash flows. For the moment, we fudge the question of how to choose discount rates; this topic is discussed in Chapter 9. 0195301501_158-192_ch7.qxd 11/3/05 12:47 PM Page 160 CHAPTER 7 Introduction

Thus, if we have correctly chosen the discount rate r for the project, the PV is what we ought to be able to sell the project for in the market.1 The net present value is the wealth increment produced by the project, so that NPV 0 means that a project adds to our wealth: NPV = CF0 ↑ Initial cash flowrequired to implement the project. This is usually a negative number. + N t=1 CFt (1 + r )t ↑ Market value of future cash flows. An Initial Example To set the stage, let’s assume that you’re trying to decide whether to undertake one of two projects. Project A involves buying expensive machinery that produces a better product at a lower cost. The machines for project A cost $1,000 and, if purchased, you anticipate that the project will produce cash flows of $500 per year for the next five years. Project B’s machines are cheaper, costing $800, but they produce smaller annual cash flows of $420 per year for the next five years. We’ll assume that the correct discount rate is 12%. 160 PART TWO CAPITAL BUDGETING AND VALUATION 1This assumes that the discount rate is “correctly chosen,” by which we mean that it is appropriate to the riskiness of the project’s cash flows. For the moment, we fudge the question of how to choose discount rates; this topic is discussed in Chapter 9. 0195301501_158-192_ch7.qxd 11/3/05 12:47 PM Page 160 CHAPTER 7 Introduction

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