Essay on Capital Budgeting Summary

2029 Words May 25th, 2008 9 Pages
Capital budgeting is the process of evaluating a company’s potential investments and deciding which ones to accept. A company’s market value added (MVA) is the sum of all its projects’ net present values (NPVs). Basically, one can calculate the free cash flows (FCFs) for a project in much the same way as for a firm. When a project’s free cash flows are discounted at the appropriate risk-adjusted rate, the result is the project’s value. One difference between valuing a firm and a project is the rate that is used to discount cash flows. For a firm, it is the overall weighted cost of capital, while for a project, it is r, the project’s risk adjusted cost of capital. Subtracting the initial cost of a project gives the NPV of the project. …show more content…
Since the discounted payback period for project S is smaller, project S is preferred to project L. For this example, both the regular and discounted payback period methods produce similar results.
Net Present Value (NPV)
The NPV method is based on the discounted cash flow (DCF) techniques. The steps to implement the approach are:
1) Find the present value of each cash flow, including all inflows and outflows, discounted at the project’s cost of capital;
2) Sum the discounted cash flows; the sum is defined as the project’s NPV.
3) If the NPV is positive, the project should be accepted. If the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen.
NPV = CF0 + + … + =
Assuming a 10% cost of capital, project S’s NPV can be calculated as:
NPVS = -1000 + + + + = 78.82 dollars.
The rationale for the NPV method is straightforward. If a project has a positive NPV, it is generating more cash than is needed to service the debt and to provide the required return to shareholders. In addition, NPV is equal to the present value of the project’s future economic values added (EVAs).
Internal Rate of Return (IRR)
The internal rate of return (IRR) method is similar to the idea of finding the yield to maturity, or rate of return, on a bond. The IRR is defined as the discount rate that forces

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