Chapter 3 - Opportunity cost of capital and capital budgeting. The main contents of the chapter consist of the following: Opportunity cost of capital, interest rate fundamentals, capital budgeting: the basics, capital budgeting: some complexities, alternative investment criteria. | Opportunity Cost of Capital and Capital Budgeting Chapter Three Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Opportunity Cost of Capital Opportunity cost of capital: benefits of investing capital in a bank account that is forgone when that capital is invested in some other alternative. Importance for decision making: when expected cash flows occur in different time periods. Capital budgeting: analysis of investment alternatives involving cash flows received or paid over time. Capital budgeting is used for decisions about replacing equipment, lease or buy, and plant acquisitions. 3- Time Value of Money A dollar today is worth more than a dollar tomorrow, because you could invest the dollar today and have your dollar plus interest tomorrow. Value at end Alternative of one year A. Invest $1,000 in bank account earning 5 percent per year $1,050 B. Invest $1,000 in project returning $1,000 in one year $1,000 Alternative B forgoes the $50 of interest that could have been earned from the bank account. The opportunity cost of selecting alternative B is $1,050. 3- Present Value Concept Since investment decisions are being made now at beginning of the investment period, all future cash flows must be converted to their equivalent dollars now. Beginning-of-year dollars (1 Interest rate) = End-of-year dollars Beginning-of-year dollars = End-of-year dollars (1 Interest rate) 3- Interest Rate Fundamentals FV = Future Value PV = Present Value r = Interest rate per period (usually per year) n = Periods from now (usually years) Future Value of a single flow: FV = PV (1 + r)n Present Value of a single flow: PV = FV (1 + r)n Discount factor = 1 (1 + r)n 3- Interest Rate Fundamentals Present value of a perpetuity (a stream of equal periodic payments for infinite periods) PV = FV r Present value of an annuity (a stream of equal periodic payments for a fixed number of years) PV = (FV r) {1 – [1 (1 + r)n]} | Opportunity Cost of Capital and Capital Budgeting Chapter Three Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Opportunity Cost of Capital Opportunity cost of capital: benefits of investing capital in a bank account that is forgone when that capital is invested in some other alternative. Importance for decision making: when expected cash flows occur in different time periods. Capital budgeting: analysis of investment alternatives involving cash flows received or paid over time. Capital budgeting is used for decisions about replacing equipment, lease or buy, and plant acquisitions. 3- Time Value of Money A dollar today is worth more than a dollar tomorrow, because you could invest the dollar today and have your dollar plus interest tomorrow. Value at end Alternative of one year A. Invest $1,000 in bank account earning 5 percent per year $1,050 B. Invest $1,000 in project returning $1,000 in one year $1,000 Alternative B forgoes the $50 of
