Week 8 – Net Present Value and Other Investment Criteria

The process of allocating or budget capital is usually more involved than just deciding whether to buy a particular non-current asset. We frequently face broader issues, such as whether we should launch a new product or enter a new market.

The process of capital budgeting could thus be given a more descriptive name: strategic asset allocation. The capital budgeting question is probably the most important issue in corporate finance. How a firm chooses to finance its operations are certainly issues of concern, but the non-current assets define the business of the firm.

Types of Projects

* A conventional project is one that has an initial cash outflow, followed by one more expected future net cash inflow (i.e. buying a stock or bond)

* A non-conventional project may have several net cash outflows and inflows * Some net cash outflows may occur in the future

* Two projects are independent if undertaking one does not affect the other. But the limitation is the fund available for the company.

* Two projects are mutually exclusive if taking one of them means we cannot take the other (taking one investment prevents the taking of another).

Non-discounted Cash Flow Methods

* Payback period
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Accept: Payback period is less than benchmark
Reject: Payback period is greater than benchmark

1) Find out which years initial investment is in 2) Work out how much is to be recovered 3) To find out fractional year divide this figure by 2nd year CF 4) Add fractional year to number of years so far

Advantages: * Easy to understand * Adjusts for uncertainty of later CF’s * Biased towards liquidity

Because it is biased towards short-term