chapter8a - Chapter 8 Net Present Value and Other...

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Unformatted text preview: Chapter 8 Net Present Value and Other Investment Criteria Understand the net present value rule and why it is the best decision criteria Understand other investment criteria and their drawbacks 2 Net Present Value Definition: Difference between the market value of a project and its cost NPV = – initial cost + PV(future cash flow) Decision rule: Accept if the NPV is greater than zero Reject if the NPV is less than zero • The Alpha Corporation is considering investing in a riskless project costing $100. The project would receive $107 in one year and have no other cash flows. The discount rate for a risk-free project is 6 percent. How do we interpret the NPV of $.94? By undertaking this project, the firm would create $.94 more than other investment opportunities with comparable risk in terms of today’s dollars. Why use NPV rule? • Key features of NPV rule: − NPV uses cash flows − NPV uses all the cash flows of the project − NPV discounts the cash flows properly • Competitors: − Payback period rule − Average accounting return − Internal rate of return (IRR) Payback period method Payback period = number of years taken to get the initial cost back Decision rule: accept if the payback period is shorter than some cutoff Example: Project C C 1 C 2 C 3 C4 Payback NPV at period r=.10 A-100 50 50 0 60 2 21.52 B-100 50 30 40 40 2.5 12.59 C-100 30 50 40 60,000 2.5 40,966.08 Advantages and Disadvantages of Payback Problems: 1) Ignores the time value of money within the payback period 1) Totally ignores payments after the payback period 1) Cutoff date is arbitrary: Set it short tend to reject positive NPV projects Set it long tend to accept negative NPV projects Why would firms ever use such silly rules? Simple and easy to understand Easy to check ex post whether decision was correct If firm is cash constrained, quick payback may allow reinvestment Average Accounting Return Basic approach is to calculate: average net income / average book value of investment (There are many different definitions) Example: Consider a project that costs $9,000 and generates incomes...
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This note was uploaded on 06/20/2010 for the course CB EF4441 taught by Professor Professorng during the Spring '10 term at 東京国際大学.

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chapter8a - Chapter 8 Net Present Value and Other...

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