Relation between NPV and Company Value and Stock Price

In theory, positive NPV project will increase stock price by the project’s NPV per share.

In reality, the stock price reflect the investor’s expectation on the ability of the firm to identify positive NPV projects.

Relative popularity of various capital budgeting methods

Larger firms, public companies and firms with educated management:
· tend to use NPV and IRR.

Private firms and European firms:
· tend to use payback period.

Internal Rate of Return (IRR)

Please see “NET PRESENT VALUE (NPV) vs. INTERNAL RATW OF RETURN (IRR)”

Net Present Value (NPV)

Please see “NET PRESENT VALUE (NPV) vs. INTERNAL RATW OF RETURN (IRR)”

Profitability Index (PI)

PI = PV (future's cash flows)/ initial cash outlay

Rule: If greater than one, accept the project; otherwise reject.

Average accounting rate of return (AAR)

Based on accounting income but not cash flows and not account for time value of money.

AAR = Project's average net income / Project's average book value

Discounted payback period

· The number of years (including fractions) that it takes discounted cash inflows from project to equal original investment.
· Longer period than regular payback.

Rules:
If discount payback period is smaller than benchmark, accept ; otherwise, reject;

Drawbacks: not consider cash flow beyond payback period.

Payback Period (PP)

Number of years (including fractions) that it takes the nominal cash inflows equal to the original investment in a project. Payback period is a good measure for project liquidity but ignore time value of money & terminal value.

PP = full years before full recovery + unrecovered amount at the beginning of the last year/cash flow in the year

For constant cash flow
PP = project cost/ annual cash flow

Rules: If payback period is smaller than benchmark, accept; otherwise, reject.

Drawbacks: not consider the cash flow beyoung payback period and the time value of money.

Classification of projects

· Replacement decisions to maintain the business
· Replacement decisions for cost reduction
· Existing product or market expansion
· New products, markets or mandatory investments

General Concept of Capital Budgeting

Capital Budgeting
Capital budgeting can be defined simply as the process of planning for projects on assets with cash flows of a period greater than one year.

The Importance of Capital Budgeting
· The firm becomes tied to the project and loses some of its flexibility during that period.
· Managers need to forecast the revenue over the life of that asset.
· Capital-budgeting decisions ultimately define the strategic plan of the company.

Typical steps of Capital Budgeting
· Generate ideas
· Analyze projects
· Create the firm’s capital budget
· Monitor decisions and conduct a post-audit

Notes:
· Post-audit: improves future forecasts and efficiency of the operations.

Key principles of capital budgeting
· Incremental cash flows – sunk costs are not considered. Externalities including cannibalization of sales should be included.
· Opportunity costs of cash flows
· Timing of cash flow
· After-tax basis for cash flows
· Financing cost – reflected in the required rate of return but NOT in the incremental cash flows