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# Chapter 9 - Net Present Value and Other Investment Criteria...

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Net Present Value and Other Investment Criteria Chapter Nine

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Chapter Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting
Good Decision Criteria We need to ask ourselves the following questions when evaluating decision criteria 1. Does the decision rule adjust for the time value of money? 2. Does the decision rule adjust for risk? 3. Does the decision rule provide information on whether we are creating value for the firm?

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Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? 1. Estimate the expected future cash flows. 2. Estimate the required return for projects of this risk level. 3. The third step is to find the present value of the cash flows and subtract the initial investment.
Net Present Value 0 1 2 3 4 5 0 1 2 3 4 5 |----------|----------|----------|----------|----------| -250 -100 -100 -100 -100 -100 +200 +200 +200 +200 +200 +100 +100 +100 +100 +100 If conventional CFs, 0 1 2 3 4 5 0 1 2 3 4 5 |----------|----------|----------|----------|----------| (-) (+) (+) (+) (+) (+)

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Net Present Value ( 29 ( 29 ( 29 1 2 0 2 1 1 1 n n C C C NPV C r r r ± ± ± = - + + +⋅⋅⋅+ + + +
NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

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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 Year 2: CF = 70,800 Year 3: CF = 91,080 Your required return for assets of this risk is 12%.
Computing NPV for the Project NPV = – 165,000 + 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 = 12,627.42 Do we accept or reject the project?

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Decision Criteria Test - NPV Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value? NPV rule is our primary decision.
Payback Period How long does it take to get the initial cost back in a nominal sense? Computation

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Chapter 9 - Net Present Value and Other Investment Criteria...

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