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Chapter 7

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
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 = + =
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 \$ = -
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 = - + =
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
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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Chapter 7 - Chapter 7 Net Present Value 1 Plan of the...

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