Chapter 7 - Chapter 7 Net Present Value 1 Plan of the...

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1 Chapter 7 Net Present Value
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2 Plan of the lecture Net present value ( NPV ) Other investment criteria and their pitfalls Project interactions Capital rationing
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3 Net present value Investment decision Which investment projects should the firm take on? Known as the investment decision or the capital budgeting decision The success and even the survival of a firm depends on its investments, especially when the amounts of money involved are large and the investments last many years (see the Eurotunnel example on pp. 208 and 209 ) This chapter discusses various criteria used to evaluate investment projects
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4 Net present value Investment decision Suppose you buy a zero-coupon government bond which will pay you $1,000 next year Interest rate on this zero-coupon bond is a risk free 6% How much would you pay for this bond? 40 . 943 $ 06 . 0 1 000 , 1 $ Price = + =
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5 Net present value Investment decision Suppose instead you had the opportunity to buy a stamp today and sell it for $1,000 guaranteed next year The bond and the stamp are both risk free; they have the same time horizon and promise the same cash flow So the price of the stamp must be equal to that of the bond: $943.40
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6 Net present value Investment decision But what if you can purchase the stamp today for merely $874.89. Are you happy with this deal? Of course! You can acquire something worth $943.40 for only $874.89 You are better off by: $68.51 is known as the net present value ( NPV ) of this stamp investment 51 . 68 $ 89 . 874 $ 40 . 943 $ = -
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7 Net present value Investment decision 0 1 $1,000 6% -$874.89 $1,000/(1+0.06) = $943.40 NPV = $943.40 - $874.89 = $68.51 The time line of the stamp investment cash flows
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8 Net present value Investment decision The NPV is defined as present value of cash flows minus initial investment NPV = PV – initial investment 51 . 68 $ 89 . 874 $ 06 . 0 1 000 , 1 $ NPV = - + =
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9 Net present value NPV measures the incremental value (minus the initial investment) created by investing in a project The NPV rule says that managers can increase shareholders’ value by accepting all projects that are worth more than their costs (i.e., all projects with a positive NPV )
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10 Net present value Investment decision The discount rate is known as the opportunity cost of capital It is the expected rate of return given up by investing in a project You give up the opportunity to buy a 6% zero- coupon government bond to purchase a stamp instead But although government bond is risk free, stamps are not! So we should use a higher opportunity cost of capital for stamps
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11 Net present value Investment decision Suppose the stamp is as risky as the market yielding 12%, then for the stamp the opportunity cost of capital should be 12% The NPV becomes: 51 . 68 $ 97 . 17 $ 89 . 874 $ 12 . 1 000 , 1 $ NPV < = - = A risky dollar is worth less than a safe one
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12 Net present value The NPV concept can also be applied to multiple-year projects NPV C C r C r C r t t = + + + + + + + 0 1 1 2 2 1 1 1 ( ) ( ) ...
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This note was uploaded on 01/26/2010 for the course ADMS 3530 taught by Professor Unknown during the Spring '09 term at York University.

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Chapter 7 - Chapter 7 Net Present Value 1 Plan of the...

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