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Chapter 17:
is the stock of assets that will generate a flow of income in the future.
Capital budgeting: is the planning process for allocating all expenditures that will have an expected benefit to the firm for more than one year.
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Investment Appraisal
Firms normally place projects in the following categories:
2.
3. 4.
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Payback-period criterion:
Payback period is the amount of time sufficient to cover the initial cost of an investment But it ignores any returns accrue after the pay-back period; ignores the pattern of returns; ignores the time value (time cost) of money.
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Example: Initial investment: Cash flow: Payback-period? $10 million $2 million per year
Discounting On the other hand, the process of discounting or capitalization is to turn a future stream of services or income into its equivalent present value. When an expected future sum is turned into its equivalent present value, we say that it is discounted or capitalized.
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PV= (1+r)n
Suppose we try to find the present value of a single future amount of $121, to be received after two years. Since goods available in the future are worth less than the same goods available now, the future amount of $121 is worth less than $121 at present. Given the market rate of interest of 10%, its present value is: $121
(1+0.1)2
= $100
This means that the future amount of $121 (to be received after two years) is equivalent to a value of $100 at present.
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Simple Technique for Appraisal of Investment Net-present-value technique: Net present value (NPV) is the difference between the present value of a future cash flow and the initial cost of the investment project; a firm should adopt a project if the expected NPV is positive.
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or I NPV = -P + r
where: P: =capital cost, accruing in full at the beginning of the project
I1,2,n =net cash flows arising from the project in years 1 to n r =the opportunity cost of capital
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Simple Technique for Appraisal of Investment Internal-rate-of-return method: Internal rate of return (IRR) is the rate of return that will equate the present value of a multi-year cash flow with the cost of investing in a project.
Using the NPV equation: the IRR is the discount rate that renders the NPV of the project equal to zero.
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P, n and the expected future cash returns (I) are known, we try to find IRR.
If the IRR is greater than the market rate of interest r, it implies that the present value of the capital good (PV) is greater than its purchase price (P) and the firm should invest. Conversely, if IRR is smaller than r, it implies that PV is smaller than P and the firm should not invest.
In most situations, the IRR method will yield the same results as the NPV method. But:
there may be more than one value for the IRR that satisfies the NPV equation; if the sign of cash flows changes more than once in the life of the project, there may be multiple solutions the NPV rule uses actual opportunity cost of capital as the discount rate; the IRR rule assumes the shareholders can invest at the IRR IRR is expressed in terms of a percentage rate of return, it ignores the projects absolute effect on the wealth of shareholders
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D
(D + E)
+ re
E
(D + E)
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If they were not the same, investors could improve their position by arbitrage, selling the shares of one and buying shares in the other, which would alter the relative prices of shars until the WACCs become equal
The level of gearing is therefore irrelevant to the WACC and the value of the firm
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Rate of return = Dividend/Price + Expected Dgrowth rate re = 1 + g P0 The DVA relies on the equivalence of the market price of a stock, P0, with the present value of the dividends ( or cash flows) expected from the stock. The discount rate in finding the present value is considered to be the cost of equity capital.
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Assumptions
There are few assumptions behind the method: (a) future dividends are expected to grow at a constant rate perpetually; (b) future dividends can be discounted at a constant cost of equity capital; (c) future dividends remain a constant proportion of earnings over time;
(d) the firm is an all-equity-financed firm, or it has a constant level of leverage (or a constant debt-equity ratio). 21
DVA:
discounted rate, cost of equity capital Dt ] PV= [ t (1 + r) Assume D1 grows at constant rate of g:
(1 + g) Let B = (1 + r) (1)
PV B = A(B + B2 + B3 + )
(2) - (1): PV(1 - B) = A PV = A (1 - B) D1 (1 + r) PV = (1 + r) (r - g) Given PV = P0 D1 r= P +g 0
(2)
1-B = 1 - (1 + g) (1 + r) (1+r) -(1 + g) = (1 + r) (r - g) = (1 + r) D1 = D0 (1 + g)
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In the CAPM, the measure of market risk is known as beta (). For example, the returns from an asset with a beta of 0.5 will fluctuate by 5% for each 10% fluctuation in the markets returns. It has been shown that the required risk premium for an asset is directly proportional to its beta. Therefore, the holder of an asset with a beta of 0.5 will require a risk premium only half as large as that offered by the market as a whole. If the market is efficient, the cost of equity capital will be equal to the expected rate of return.
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