ch 9 (Investment Criteria)

ch 9 (Investment Criteria) - 9 Net Present Value and Other...

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9 Net Present Value and Other Investment Criteria Slide 9 - 1 Capital Budgeting Decisions Capital budgeting decision is also called investment decision, which involves such issues as: Whether or not to invest in a particular project? When faced with several projects and limited resources, pick the best project to invest in. We discuss these issues in Chapter 9, 10, and 11. Concept of Capital Budgeting

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Slide 9 - 2 Good Decision Criteria Evaluate Decision Rules To evaluate capital budgeting decision rules, we need to ask ourselves the following questions: Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? Slide 9 - 3 An Example A factory costs \$400,000. You forecast that it will produce cash inflows of \$120,000 in year 1, \$180,000 in year 2, and \$300,000 in year 3. The discount rate is 12 percent. Is the factory a good investment? We need to compare the cost and the benefit of the investment. To do so, we convert all cash flows to time 0 (or to any time point). The present value of all cash inflows, \$464,171.83, is more than the present value of cash outflow, \$400,000. The factory is a good investment. The net benefit \$64,171.83 is the Net Present Value of this investment. 83 . 171 , 464 \$ 12 . 1 000 , 300 \$ 12 . 1 000 , 180 \$ 12 . 1 000 , 120 \$ PV 000 , 400 \$ PV 3 2 benefit cost = + + = = Net Present Value: Concept
Slide 9 - 4 Definition of NPV Net present value (NPV) is the difference between the market value of its future cash flows and the initial cost. Determine the Value Created from an Investment Step 1: Estimate the expected future cash flows. Step 2: Estimate the required return for projects of this risk level. Step 3: To find the present value of the cash flows and subtract the initial investment – to find the NPV of all the cash flows. Net Present Value: Concept Slide 9 - 5 Decision Rule Accept the project if the NPV is positive. Understand Positive NPVs 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. The NPV Rule

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Slide 9 - 6 Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate \$16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for \$450,000. How much would you be willing to pay for the building? Assuming a discount factor of 7 percent. If the building is being offered for sale at a price of \$350,000, would you buy the building and what is the added value generated by your purchase and management of the building? The NPV Rule Slide 9 - 7 0 1 2 3 The NPV Rule \$16,000 \$16,000 \$16,000 \$450,000 + \$466,000 = Present Value: 14,953 13,975 380,395 \$409,323 NPV = - 350,000 + 409,32 = 59,323
Slide 9 - 8 Alternatively, In general, we have the formula Cash outflows are negative, cash inflows are positive. Usually, C 0 is cash outflow, so it’s negative.

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This note was uploaded on 11/07/2010 for the course FINANCE fina1003 taught by Professor Zhoux during the Spring '10 term at HKU.

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ch 9 (Investment Criteria) - 9 Net Present Value and Other...

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