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Making of Capital Investment Decisions

•What is the difference between NPV,IRR, Payback analysis and how are these methods related?
•What are examples of opportunity costs and incremental cash flows?
•How does the cash flow of a project impact whether or not a company pursues a certain project?
•Give an example of how you would employ the different capital budgeting techniques to a real life situation or a situation you can envision. How would you differentiate among three different projects if you could only pursue one of those projects?

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In all of these questions, the concept of time value of money is the prime ingredient. Time value of money refers to the loss of value of a currency over time due to economic pressures on that currency --- pressures such as price changes, interest rate changes, changes due to purchasing power, and the like. The reference is that, over time, a currency will lose value due to economic conditions. Having said that, net present value refers to the attempt to determine the present value of future sums of cash as a result of any particular investment strategy.(by discounting the future values of cash projections to the present using a discount factor which represents our determination of risk plus that which we could or are already earning on current investments).

Firms will often invest long term in projects designed to increase their ability to grow the business. This can take the form of increases in sales, increasing market coverage, increasing market presence (new products, etc.), reducing expenses, or any combination of the above. In order to determine if a project is worthy of investment, a firm tries to determine the cash flow which will arise from that project --- this is done in forecasting terms based upon the following formula:

Free cash flow = revenue - expenses (EBIT) x (1 - tax rate) + depreciation - changes in working capital - capital expenditures (capex). So what the firm is trying to determine is the rate or amount of cash flow which will be realized from an investment opportunity. In order to calculate the actual value of these future cash flows, the method of determining the actual value is to bring those future values back to the present in order to have an understanding and appreciation ...

Solution Summary

A discussion of decision criteria for approving or disproving investment opportunities