Fin 351 Quiz 2 Guide.docx - ~Net Present Value present...

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~ 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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