ECOS2201-prelect12 - S I D E R E M E N S E A D E M M U T A...

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Unformatted text preview: S I D E R E M E N S E A D E M M U T A T O University of Sydney ECOS2201 - Lecture 12 1 Project Selection Which projects should a firm undertake? Calculate Net Present Value of projects revenues and costs and undertake if positive 2 Net Present Value $100 today at annual interest rate of 10% becomes $110 in one year So present value of $110 in one year is NPV = FV 1 + r = 110 1 . 1 = 100 (1) 3 More generally, if get stream of payments in the future, F 1 in one year, F n in n years, then NPV = F 1 1 + r + F 2 (1 + r ) 2 + ... + F n (1 + r ) n (2) Question: Consider a silver mine that requires an investment of 2 mill. immediately and 1 mill. after 1 year, two years, three years, and four years. The mine then starts producing silver and yields net revenue of 750,000 in years 5 to 44 (40 years). Write down formula for NPV? 4 Answer: See board. At r = . 05, NPV=5,042,000 At r = . 1, NPV=-160,000 So undertake project if r = . 05 but not if r = . 1 5 Often stream of payments is uncertain- price of silver varies as do costs How do we take risk into account when selecting projects? The basic problem - which projects increase a firms value and which projects decrease a firms value? 6 Every project has a cost and produces a random risky stream of net payments Therefore, it is like a share (asset) - it has a cost and a risky stream of payments (dividends) Undertake project (buy a share) if value of risky stream of payments is greater than cost. BUT what interest rate use to discount future values ? How do we do NPV calculation? 7 Expected Return and Variance for a Single Asset Rate of return given by R = p 1- p p , (3) where p 1 is value of asset in period 1 and a random variable and p is value of asset in period 0....
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ECOS2201-prelect12 - S I D E R E M E N S E A D E M M U T A...

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