~
Net Present Value
: present value of cash flows minus initial investments(NPV=PV-Initial Investments)-apply to
risky investments (measures difference between its value and cost)
~
Opportunity Cost of Capital (Discount rate)
: expected rate of return given up by investing in a project (its called
opportunity cost because if you decide to invest in this project you will forgo other similar investment opportunity)
~
Present value
=market price or market value(to calculate the present value we discounted the expected future
payoff by the rate of return offered by comparable investment alternatives.
~
The Net Present Value rule
states that the managers increase shareholder’s wealth by accepting projects that are
worth more than they costs. Accept project with positive NPV
~If you have the opportunity to purchase an office building , you have a tenant lined up that will generate $25,000
per year in cash flows for three years. At the end of the three years you anticipate selling the building for $450,000.
How much would you willing to pay for the building assuming 7% opportunity cost?
~
Internal Rate of Return(IRR)
- Disc. rate at which NPV=0,
IRR rule- invest in a any project offering an IRR that is
higher than the opportunity cost of capital
~Ex. you can purchase bldg. For $375,000. The investment will generate $25,000 cash flow (rent) during 3 yrs. At
the end of 3 yrs u sell the bldg. For $450,000. What is IRR?- 12.56% {0=-375,00+25,000/(1+IRR)^1 + 25,000/
(1+IRR)^2+475,000/(1+IRR)^3}
~For mutually exclusive projects: calculate NPV & choose that have POSITIVE &
offers HIGHER
NPV (IRR cannot
rank the mutually exclusive projects)
~
IRR = discount rate when NPV=0
(opportunity cost < IRR, NPV +, if opportunity cost > IRR ,NPV-)
~As the discount rate increases NPV falls and vice versa.
~Profitability Index(PI)
= ratio of net present value (NPV) to initial investment (NPV/Initial Inv.)
Accept the project if
PI >0
(any project with +PI also have +NPV)
~
Payback Period
:Time until CF recover the initial invest. of the project (ex. Initial investment/next yr cash flow)
~The payback rule specifies that a project be accepted if it's payback period is less than specified cut off period
(accept project if payback period is < some specified number of years.) *is shortest payback period as highest

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