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Video 37 (Topic 7.3): Other Issues

Video 37 (Topic 7.3): Other Issues. FIN 614: Financial Management Larry Schrenk, Instructor. Topics. Projects with Unequal Lives Replacement Chains Equivalent Annual Annuities (EAA) Final Thoughts. Evaluating Projects with Unequal Lives.

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Video 37 (Topic 7.3): Other Issues

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  1. Video 37 (Topic 7.3):Other Issues FIN 614: Financial Management Larry Schrenk, Instructor

  2. Topics • Projects with Unequal Lives • Replacement Chains • Equivalent Annual Annuities (EAA) • Final Thoughts

  3. Evaluating Projects with Unequal Lives • If two projects have unequal time horizons, we need to make adjustment before computing NPV. • (Equivalent) Solutions • Replacement Chains • Equivalent Annual Annuities (EAA)

  4. Uneven Lives Example▪ • Consider these two mutually exclusive projects (r = 10%): • NPVA = $413.22 and NPVB $568.27 • Is B the better project? • What about the return on our funds in years 3 and 4, if we accept Project A?

  5. Replacement Chains • Evaluate each project over an equal time horizon. • Compare NPV and IRR over extended periods.

  6. Replacement Chain Example • Evaluate each project over an equal time horizon. • Repeat Project A, so that it covers the same time horizon as Project B (r = 10%). • Recalculate NPV*A over 4 years horizon. • NPV*A = $754.73 > NPVB $568.27→ Project A

  7. Equivalent Annual Annuities (EAA) Approach • Find NPV for each project. • Convert these NPV’s into equivalent annual annuity payments. • Select the project with the higher equivalent annual annuity payments

  8. EAA Example • NPVA= $413.22 and NPVB $568.27 • EEAA N = 2; I% = 10; PV = -413.22; PMT = ???; FV = 0 PMT (EEA) = $238.09 • EEAB N = 4; I% = 10; PV = -568.27; PMT = ???; FV = 0 PMT (EEA) = $179.27 • EEAA > EEAB → Project A

  9. Choosing the Optimal Capital Budget • Finance theory says to accept all positive NPV projects. • Two problems if not enough internally cash to fund all these projects: • Increasing Marginal Cost of Capital • Capital Rationing

  10. Increasing Marginal Cost of Capital • Flotation costs with externally raised capital increases the cost of capital • Large capital projects seen as risky, which drives up the cost of capital • If external funds needed, then the NPV should be estimated using this higher marginal cost of capital

  11. Capital Rationing • Capital Rationing: Company cannot fund all positive NPV projects • Possible Reasons: • Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. • Companies don’t have enough staff to implement all positive NPV projects.

  12. Video 37 (Topic 7.3):Other Issues FIN 614: Financial Management Larry Schrenk, Instructor

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