1 Chapter 6: Analyzing Investment Projects Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objective Explain Capital Budgeting Develop Criteria

2 Chapter 6 Contents 1 The Nature of Project Analysis1 The Nature of Project Analysis 2 Where do Investments Ideas come from?2 Where do Investments Ideas come from? 3 The NPV Investment Rule3 The NPV Investment Rule 4 Estimating a Project.s Cash Flows4 Estimating a Project.s Cash Flows 5 Cost of Capital5 Cost of Capital 6 Sensitivity Analysis6 Sensitivity Analysis 7 Analyzing Cost-Reducing Projects 8 Projects with Different Lives 9 Ranking Mutually Exclusive Projects 10 Inflation & Capital Budgeting

3 Objectives To show how to use discounted cash flow analysis to make decisions such as:To show how to use discounted cash flow analysis to make decisions such as: –Whether to enter a new line of business –Whether to invest in equipment to reduce costs

4 Do Project DCF Payback

5 Don’t Do Project

6 Indifferent Internal Rate of Return

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8 Average Cost of Capital: Example with 3-Securities LetLet k e be the return on equityk e be the return on equity k d be the return on debtk d be the return on debt k p be the return on preferredk p be the return on preferred V e be the market value of issued equityV e be the market value of issued equity V d be the Market value of issued bondsV d be the Market value of issued bonds V p be the market value of issued preferredV p be the market value of issued preferred t be the tax ratet be the tax rate

9 Average Cost of Capital: Example with 3-Securities k = k e * V e + k p * V p + k d * V d * (1 - t)k = k e * V e + k p * V p + k d * V d * (1 - t) The average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market valueThe average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market value

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12 Was 15%

13 Was 40%

14 Was 0%

15 Was 75%

16 Was $3,100,000

17 Table 6.4 Project Sensitivity to Sales Volume

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