Chap009

Chap009 - Chapter 9 NPV and Other I nvestment Criteria Good...

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Chapter 9 NPV and Other Investment Criteria

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Good Decision Criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rules Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?
Project Example Information 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 assets of this risk is 12%.

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Net Present Value: NPV=PV(cash flows) – initial cost The difference between the market value of a project and its cost How much value is created from undertaking an investment? This is measured by taking the present value of the future cash flows and subtracting the initial cost. If NPV>0, then the project is worthwhile; it adds value. The rate used to discount the cash flows must be appropriate for the level of risk of the cash flows (more on this in Chapter 15).
Computing NPV for the Project Using the formulas: NPV = 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 – 165,000 = 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 Since NPV is positive, accept the project.

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Decision Criteria Test - NPV Does the NPV rule account for the time value of money? Yes. Does the NPV rule account for the risk of the cash flows? Yes. Does the NPV rule provide an indication about the increase in value? Yes. Should we consider the NPV rule for our primary decision rule? Yes.
Payback Period How long does it take to get the initial cost back in a nominal sense, i.e. ignoring time value of money and discount rates? Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule – Accept if the payback period is less than some preset limit

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Computing Payback For The Project Assume we will accept the project if it pays back within two years. Year 1: 165,000 – 63,120 = 101,880 still to recover Year 2: 101,880 – 70,800 = 31,080 still to recover Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3 We reject the project because we still had \$31,080 to recover after year 2.
Decision Criteria Test - Payback Does the payback rule account for the time value of money? No. Does the payback rule account for the risk of

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This note was uploaded on 01/09/2010 for the course HADM 2225 taught by Professor Wellman, j during the Winter '08 term at Cornell.

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Chap009 - Chapter 9 NPV and Other I nvestment Criteria Good...

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