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Unformatted text preview: Chapter 5 - Net Present Value and Other Investment Criteria ECO389, Spring 2010 The investment decision, also known as Capital Budgeting , is central to the success of the company. We have already seen that capital investments sometimes absorb substantial amounts of cash; they also have very long-term consequences. The assets you buy today may determine the business you are in many years hence. 1 Net Present Value 1.1 The Rationale 1. Definition: The sum present value of the future cash ows minus the investment outlay is the net present value . 2. Net present value measures each projects contribution to shareholder wealth. 3. While there are several long-term investment decision criteria, the net present value method is favored because it tends to focus on building shareholder value and has the fewest limiting assumptions. 1.2 A review of the Basics 1. Capital budgeting decisions : the process of choosing investment projects, are important because they usually involves large cash outlays with cash ow return over a long period of time. 2. The financial managers will always ask: What is a good project, what is a bad project? This is our investment criteria . 1 3. How do we measure the value of an investment project? The four steps in the capital budgeting decision process are: (a) In order to find the PV we need to forecast all of the future cash ows associated with the project throughout its useful life, noting when the ow occurs. How good can our forecasts be? Do not overestimate revenues and underestimate costs! (b) Estimate the opportunity cost of capital. The opportunity cost of cap- ital is the expected rate of return given up by investing in the project under review. We use the opportunity cost of capital as discounting rate to discount the cash ow back to the present. How do we find this rate? How do we measure risk? Assumption : For now, lets assume that we can have accurate estimates of all future cash ows as well as the opportunity cost of capital. (c) Calculate the present value of the future cash ows discounted at the op- portunity cost of capital rate. The present value of the cash ows represents the maximum amount that investors would pay for the investment. (d) NPV Decision Rule: If the net present value is positive (greater than zero), make the investment. If the net present value is negative, forgo the investment. The net present value rule states that managers increase sharehold- ers wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value. (e) The expected net present value of a project is the added shareholders wealth provided by the project....
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This note was uploaded on 04/13/2010 for the course ECO 389 taught by Professor Chen,j during the Spring '08 term at SUNY Stony Brook.
- Spring '08