Capital Budgeting

Last updated Nov 8, 2022 Edit Source

Net Present Value: calculate the present value of future cash flows in order to whether a project is worth up taking $NPV_1\ge NPV_2$.

NOWC: This is the net change in accounts receivable, accounts payable, and inventory during the measurement period. __An increase in working capital uses cash, while a decrease produces cash.

Rate of return which makes the NPV of a project = 0. A higher IRR is better. Intuitively, if the IRR is higher, this means that the cashflows are equivalent to returns at that level of interest rate.

Dependent only on the cashflows and not the required return.

Cons:

• Non conventional cashflows makes IRR method unreliable as there may be more than 1 IRR
• The IRR can also be 0
• Assumes cash flows are reinvested at the IRR and not the WACC (unrealistic)

Relationship to NPV:

• IRR and NPV gives the same decision for independent projects.
• NPV should be used for mutually exclusive projects

Crossover rate is the rate which we are indifferent between 2 projects. Both projects have NPV = 0.

The internal rate of return which makes the present value of cash outflows = to the present value of the terminal value (FV of cash inflows) of the project.

Handles the IRR problem by combining cash flows into (-) sign cash flow at time 0 and 1 (+) sign cash flow at terminal year.