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Section7.12(2) - Chapter 7 Business Decisions Capital...

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Chapter 7 – Business Decisions, Capital Budgeting and Depreciation Net Present Value (section 7.1) Businesses are frequently faced with the problem of deciding whether an investment or business venture should be undertaken in many situations, alternative projects must be compared and a decision reached as to which one should be chosen
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One method that can be used to help make these decisions is to: 1. Estimate the future cashflows of the project 2. Discount these future cashflows at some interest rate 3. Subtract off the initial investment The resulting value is called the net present value (NPV)
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Notation F t = estimated net cashflow at the end of period t , t = 0, 1, 2, … note : F t > 0 or F t < 0 or F t = 0 F 0 = initial investment ( F 0 < 0) n = investment horizon i = cost of capital Note: The cost of capital can be thought of as the minimum rate of return that an investment must earn in order for the company to invest the money
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Thus, NPV = F 0 + F 1 (1+ i ) - 1 + F 2 (1+ i ) - 2 + … + F n (1+ i ) - n How is This Used to Make Decisions? 1. NPV 0 means the project will earn at least the cost of capital and thus should be undertaken 2. NPV < 0 means the project will earn less than the cost of capital and thus should not be undertaken
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Example 7.1.1
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