Capital Budgeting - Finance Theory, MIT Lecture 18-20

15.401




15.401 Finance Theory
MIT Sloan MBA Program



Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lectures 18–20: Capital Budgeting


© 2007–2008 by Andrew W. Lo

, Critical Concepts 15.401

ƒ NPV Rule
ƒ Cash Flow Computations
ƒ Discount Rates
ƒ Discount Rates Over Time
ƒ Project Interactions
ƒ Alternatives to the NPV Rule
ƒ The Practice of Capital Budgeting
ƒ Key Points

Readings
ƒ Brealey, Myers, and Allen Chapter 5–6, 9, 22
ƒ Graham and Harvey (2001)



© 2007–2008 by Andrew W. Lo Slide 2
Lecture 18-20: Capital Budgeting

, NPV Rule 15.401


Objective: Increase Firm’s Current Market Value
ƒ Implication: take projects with positive NPV
ƒ Project has cashflows of:




ƒ Its current market value is




ƒ This is the addition to the firm's market value by the project (recall
value additivity).



© 2007–2008 by Andrew W. Lo Slide 3
Lecture 18-20: Capital Budgeting

, NPV Rule 15.401

Investment Criteria:
ƒ For a single project, take it if and only if its NPV is positive
ƒ For many independent projects, take all those with positive NPV
ƒ For mutually exclusive projects, take the one with positive and highest
NPV

To Compute the NPV of a Project, We Need To Consider:
ƒ Cash flows
ƒ Discount rates
ƒ Strategic options




© 2007–2008 by Andrew W. Lo Slide 4
Lecture 18-20: Capital Budgeting