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npv_irr - NPV AND IRR RULES 1 2 3 4 5 6 7 8 9 10 11 12 13...

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NPV AND IRR RULES Page 1 NPV RULE FOR CAPITAL BUDGETING Choose a project if it costs less than the PV of its cash flows. More generally: take a project if its Net Present Value is positive. EXAMPLE Interest rate 10% Year 0 1 2 3 Cash flow (600) 200 200 500 PV factor 100% 91% 83% 75% PV of cash flow (600) 182 165 376 Cumulative PV (600) (418) (253) 123 Net Present Value 123 Investors would have to invest 123 more (a total of 723) to get the cash flows of 200, 200, and 500 at an interest rate of 10%. Therefore the project has a value of 123 for investors. The interest rate is called the cost of capital, because it is the opportunity cost of funds - the rate investors can earn on alternative investments. A B C D E F G H 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22
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NPV AND IRR RULES Page 2 IRR RULE For a standard project, NPV > 0 if and only if IRR > Cost of Capital IRR Rule: Choose a project if and only if IRR > Cost of Capital Standard means - cash outflows occur in early years and cash inflows in later years.
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