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Classnotes_Chapter_9

# Classnotes_Chapter_9 - Classnotes Chapter Nine Chapter Nine...

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Classnotes Chapter Nine Chapter Nine Net Present Value and Other Investment Criteria Overview Financial management involves making decisions as to what to  invest in A good investment decision is one that increases shareholder  value. Shareholder value is increased if the return on investment  exceeds the required rate of return for that investment  We therefore need a way to evaluate capital investment  projects that is consistent with our objective of maximizing  shareholder value.   Good Decision Criteria Need to be able to determine whether to invest in a project Key criterion: Does it create value for shareholders? Need to be able to determine which of many desirable projects to  undertake if we are capitally constrained Key Criterion:  Which creates the most value for shareholder? 1

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Classnotes Chapter Nine 2
Classnotes Chapter Nine Example: You are looking at a new project and you have estimated  the following cash flows: Year 0: CF = -\$165,000 Year 1: CF = \$63,120; NI = \$13,620 Year 2: CF = \$70,800; NI = \$3,300 Year 3: CF = \$91,080; NI = \$29,100 Average Book Value = \$72,000 Your required return for projects of this risk is 12%. Net Present Value (NPV) How much value is created from undertaking an investment? The first step is to estimate the expected future  cash flows. The second step is to estimate the required  return for projects of this risk level. The third step is to find the present value of the  cash flows and subtract the initial investment. Computing NPV for the Project 3

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Classnotes Chapter Nine Using the formulas: 2 3 63,120 70,800 91,080 NPV 165,000 1.12 1.12 1.12 = - + + +  = 12,627.42 Using the calculator: CF 0  = -165,000;  C01 = 63,120;  F01 = 1; C02 = 70,800;  F02 = 1;  C03 = 91,080;  F03 = 1;  NPV; I = 12;  CPT NPV = 12,627.42 NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the  firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure  of how well this project will meet our goal. 4
Classnotes Chapter Nine Net Present Value (NPV) - Advantages o Accounts for the time value of money o Accounts for the riskiness of the cash flows o Provides an indication about the increase in value Maximizing NPV is entirely consistent with maximizing  shareholder value   NPVs are additive 5

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Classnotes Chapter Nine Payback Period How long does it take to recover the initial cost?
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