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Capital budgeting

Capital budgeting. Done by : 1- Abdul- A zez Saeed Hafedh 430106898 2- Abdulmajeed Mohammed Ba- Gunaid 430104658 3- Ahmed Saeed Basager 430107147

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Capital budgeting

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  1. Capital budgeting • Done by : • 1- Abdul-AzezSaeedHafedh 430106898 • 2- Abdulmajeed Mohammed Ba-Gunaid 430104658 • 3- Ahmed SaeedBasager 430107147 • 4- Ahmed Omer Bin-Madhi 430107597

  2. What is capital budgeting • * Capital Budgeting is the process of determining which real • investment projects should be accepted and given an allocation of funds from the firm. • * Capital budgeting is the process of analyzing additionsto • fixed assets. • * Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company's • course for the future.

  3. Kinds of projects that capital budgeting ranks • Independent: -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. • Dependent:-- A project whose acceptance depends on the acceptance of one or more other projects. • Mutually exclusive: -- A project whose acceptance precludes the acceptance of one or more alternative projects.

  4. It is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.  NPV Equation: CF1 CF2CFn   (1+k)1 (1+k)2 (1+k)n NPV (L)= 18.79 NPV (s)= 19.98 Net present value(NPV)

  5. NPV = PV inflows – Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher positive NPV. Adds most value. Rational behind NPV method:

  6. 1- which franchise or franchises should be accepted if they are independent, dependent or Mutually exclusive? 2- Would the NPVs change if the cost of capital changed? Questions about NPV

  7. The internal rate of return (IRR) is that discount rate which forces the NPV of a project to equal zero Franchise L's IRR is 18.1% franchise S, IRRS is 23.6% Define the term Internal Rate Of Return (IRR)? and What is each franchise's IRR?

  8. The IRR is to a capital project what the YTM is to a bond. It is the expected rate of return on the project, just as the YTM is the promised rate of return on a bond. How is the IRR on a project related to the YTM on a bond?

  9. IRR measures a project's profitability in the rate of return sense: if a project's IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return. An IRR greater than r implies an economic profit, which accrues to the firm's shareholders, while an IRR less than r indicates an economic loss, or a project that will not earn enough to cover its cost of capital. Projects' IRRs are compared to their costs of capital, or hurdle rates. Since franchises L and S both have a hurdle rate of 10 percent, and since both have IRRs greater than that hurdle rate, both should be accepted if they are independent. However, if they are mutually exclusive, franchise S would be selected, because it has the higher IRR What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?

  10. IRRs are independent of the cost of capital. Therefore, neither IRRS nor IRRL would change if r changed. However, the acceptability of the franchises could change--L would be rejected if r were above 18.1%, and S would also be rejected if r were above 23.6%. Would the franchises' IRRs change if the cost of capital changed?

  11. If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain

  12. When you are analyzing a single conventional project, both NPV and IRR will provide you the same indicator about whether to accept the project or not. However, when comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR. This difference could occur because of the different cash flow patterns in the two projects. What is the underlying cause of ranking conflicts between NPV and IRR?

  13. The following example illustrates this point

  14. NPV method assumes CFs are reinvested at k, the opportunity cost of capital. • IRR method assumes CFs are reinvested at IRR. • Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. What is the "reinvestment rate assumption”, and how does it affect the NPV versus IRR conflict?

  15. Whether NPV or IRR gives better rankings depends on which has the better reinvestment rate assumption. Normally, the NPV's assumption is better. • ,because IRR does not account for changing discount rates, so it's just not enough for longer-term projects with discount rates that are expected to vary. Which method is the best? Why?

  16. MIRR is that discount rate which equates the present value of the terminal value of the inflows, compounded at the cost of capital, to the present value of the costs. MIRRL = 16.5%. We could calculate MIRRS similarly: = 16.9%. Thus, franchise S is ranked higher than L. This result is consistent with the NPV decision. Definition of 'Modified Internal Rate Of Return - MIRR' ? find the MIRR for franchise L and S ?

  17. MIRR is a better rate of return measure than IRR for two reasons: • (1) it correctly assumes reinvestment at the project's cost of capital rather than at its IRR. • (2) MIRR avoids the problem of multiple IRRs--there can be only one MIRR for a given project What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR's advantages and disadvantages vis-a-vis the NPV?

  18. MIRR does not always lead to the same decision as NPV when mutually exclusive projects are being considered. In particular, small projects often have a higher MIRR, but a lower NPV, than larger projects. Thus, MIRR is not a perfect substitute for NPV, and NPV remains the single best decision rule. However, MIRR is superior to the regular IRR, and if a rate of return measure is needed, MIRR should be used

  19. An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as: What does Profitability Index (PI) measure ? what are the PIs of franchise L and S?

  20. A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project. • PIs of franchise L and S : • For L = • 1.19 • For S = • 1.2

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