3064 Words13 Pages

EC100
REINHARDT
CAPITAL BUDGETING:
How a business firm decides whether or not to acquire durable real assets
In this write-up, I shall explain as simply as is possible (1) how modern business firms decide whether or not to purchase with the firm’s investible funds long-lived assets (land, machines, buildings) that will be used by the firm for more than one period and (2) how they finance these purchases. We shall explore the second question first and then illustrate the first with a numerical example. In the end, we shall explore cool, trick question with which you can annoy people in high finance—your own parents possibly among them.
A. WHENCE DOES THE FIRM GET ITS FUNDS, AND WHAT IS THE COST TO THE FIRM PER DOLLAR AND PER YEAR OF SUCH*…show more content…*

We see that the project has a positive net present value (NPV) at any hurdle rate below 18.031%. This is reassuring, if the firm’s managers believe that the cost of financing is unlikely to be that high. But you also know by now the following supreme rule of economics: Whenever two curves intersect, or a curve intersects the horizontal or vertical axis, twitch in excitement! Something wondrous is bound to be happening at that intersection. The project’s Internal Rate of Return (IRR): In this case, something truly wondrous IS happening at the discount rate at which the NPV line cuts the discount-rate axis: it is the discount rate at which the NPV of the project would be exactly equal to zero. In finance, this rate is called the project’s “internal rate of return” or IRR. It is a much-used concept in the real world of business. The IRR has its name because that rate is determined strictly by the cash flow of the project—is “internal” to it—and is not at all related to the firm’s cost of financing (k) at all. For normal projects in which one or several cash outflows are followed by a series of only cash inflows, we can offer you the following decision rule concerning the IRR of a project 2*…show more content…*

If the IRR is less than the WACC, the project should be rejected, as it impoverishes the firm’s owners. If the IRR equals the WACC, it earns only normal profits (i.e., the owners’ opportunity costs) and accepting it is a matter of indifference. In this care the project’s IRR is 18.031 > 11.88%, therefore the IRR rule tells us the same as the NPV rule: this project will enrich the firm’s owners. We note in passing that in more advanced courses in finance you would learn about projects for which this rule cannot be used. Broadly speaking, they are projects whose cash flows changes sign more than once—e.g., from negative to positive to negative again. 3 2 If the cash flow of a project changes sign more than once—e.g., if one or two outlays are followed by some inflows and then by another outflow—then this rule does not apply. Indeed, the project may then have more than one IRR. You have to take ECON 318 to learn how to cope with this mess. Let the geeks among you note that the NPV equation for an N-year project is really an N-degree polynomial of the form NPV = X0 + X1 + X2 + . . . + XN ,

We see that the project has a positive net present value (NPV) at any hurdle rate below 18.031%. This is reassuring, if the firm’s managers believe that the cost of financing is unlikely to be that high. But you also know by now the following supreme rule of economics: Whenever two curves intersect, or a curve intersects the horizontal or vertical axis, twitch in excitement! Something wondrous is bound to be happening at that intersection. The project’s Internal Rate of Return (IRR): In this case, something truly wondrous IS happening at the discount rate at which the NPV line cuts the discount-rate axis: it is the discount rate at which the NPV of the project would be exactly equal to zero. In finance, this rate is called the project’s “internal rate of return” or IRR. It is a much-used concept in the real world of business. The IRR has its name because that rate is determined strictly by the cash flow of the project—is “internal” to it—and is not at all related to the firm’s cost of financing (k) at all. For normal projects in which one or several cash outflows are followed by a series of only cash inflows, we can offer you the following decision rule concerning the IRR of a project 2

If the IRR is less than the WACC, the project should be rejected, as it impoverishes the firm’s owners. If the IRR equals the WACC, it earns only normal profits (i.e., the owners’ opportunity costs) and accepting it is a matter of indifference. In this care the project’s IRR is 18.031 > 11.88%, therefore the IRR rule tells us the same as the NPV rule: this project will enrich the firm’s owners. We note in passing that in more advanced courses in finance you would learn about projects for which this rule cannot be used. Broadly speaking, they are projects whose cash flows changes sign more than once—e.g., from negative to positive to negative again. 3 2 If the cash flow of a project changes sign more than once—e.g., if one or two outlays are followed by some inflows and then by another outflow—then this rule does not apply. Indeed, the project may then have more than one IRR. You have to take ECON 318 to learn how to cope with this mess. Let the geeks among you note that the NPV equation for an N-year project is really an N-degree polynomial of the form NPV = X0 + X1 + X2 + . . . + XN ,

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