AEM 324 CH 9 notes - Chapter 9 NPV and Other Investment...

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Chapter 9 NPV and Other Investment Criteria Capital Budgeting - Strategic asset allocation; trying to determine whether a proposed investment or project will be worth more than it costs 9.1 Net Present Value (NPV) Investment worth undertaking if it creates value for owners NPV is a measure of how much value is created or added today by undertaking an investment Discounted Cash Flow (DCF) Valuation- Process of valuing an investment by discounting its future cash flows. If you have 1000 shares of common stock outstanding and the estimate of a project is -2422 then you would expect to lose $2.42 per share from this investment Net Present Value Rule - Investment should be accepted if the NPV is positive and rejected if it is negative 9.2 The Payback Rule (“Break-even” measure in an accounting sense) Length of time it takes to recover out initial investment Pay back Period Rule - Investment is acceptable if its calculated payback period is less than some pre-specified number of years A rapid payback period does not indicate a good investment Problems with the payback period: 1. No discounting is done so time value of money is ignored 2. Does not take into account any risk involved in the investment 3. Coming up with the right cutoff period (biggest problem) is that we don’t have any objective basis for choosing a particular number. Any Cash flow after the cutoff period (if one is given) are ignored. Shortcomings with Payback Rule: 1. By ignoring time value of money we may end up with an investment that is worth less than it costs. 2. By ignoring cash flows beyond the cutoff we may reject a long term project that is profitable 3. This Rule will tend to bias us towards short term investments Redeeming qualities of Payback Rule: 1. Its simplicity quality is appealing 2. Since it is biased toward short term investments it is biased towards liquidity 3. Cash flows that occur later in the investment project are more uncertain so this clearly favors short term investments 9.3 Discounted Payback (Break-even in a financial or economic sense) Length of time required for an investment’s discounted cash flows to equal its initial cost. Discounted Payback rule - investment is acceptable if its discounted payback is less then some pre-specified number of years This takes into account the money spent along with the interest we could have earned else where If a project pays back on a discounted basis then it must have a positive NPV (Not always true only holds under the assumptions that first cash flow is negative and the rest are positive)
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Not used too much in practice because it is no simpler than the NPV Problems: 1. Cutoff is still arbitrarily set 2. Cash flows beyond cutoff are ignored If the cutoff went on forever it would be the same as the NPV rule and the profitability index rule (discussed later) Advantages: 1. Includes time value of money
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This note was uploaded on 08/03/2008 for the course AEM 3240 taught by Professor Curtis,r. during the Fall '07 term at Cornell University (Engineering School).

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AEM 324 CH 9 notes - Chapter 9 NPV and Other Investment...

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