FIN
Chapter 8

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

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CHAPTER 8 Net Present Value and Other Investment Criteria

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Topics Covered Net Present Value Other Investment Criteria Mutually Exclusive Projects Capital Rationing
Net Present Value Net Present Value - Present value of cash flows minus initial investments. Opportunity Cost of Capital - Expected rate of return given up by investing in a project

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Net Present Value Example Q: Suppose we can invest \$50 today & receive \$60 later today. What is our increase in value? Initial Investment Added Value \$50 \$10 A: Profit = - \$50 + \$60 = \$10
Net Present Value Example Suppose we can invest \$50 today and receive \$60 in one year. What is our increase in value given a 10% expected return? This is the definition of NPV Profit = -50 + 60 1.10 = \$4.55 Initial Investment Added Value \$50 \$4.55

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Valuing an Office Building Step 1: Forecast cash flows Cost of building = C 0 = 350,000 Sale price in Year 1 = C 1 = 400,000 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7%
Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment 832 , 373 ) 07 . 1 ( 000 , 400 ) 1 ( 1 = = = + + r C PV 832 , 23 832 , 373 000 , 350 = + - = NPV

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Risk and Present Value Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs 832 , 373 .07 1 400,000 PV 7% at \$400,000 C of PV 1 = + = =
Risk and Present Value 143 , 357 .12 1 400,000 PV 12% at \$400,000 C of PV 1 = + = = 832 , 373 .07 1 400,000 PV 7% at \$400,000 C of PV 1 = + = =

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Net Present Value NPV = PV - required investment NPV C C r t t = + + 0 1 ( ) NPV C C r C r C r t t = + + + + + + + 0 1 1 2 2 1 1 1 ( ) ( ) ... ( )
Net Present Value Terminology C = Cash Flow t = time period of the investment r = “opportunity cost of capital” The Cash Flow could be positive or negative at any time period.

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Net Present Value Net Present Value Rule Net Present Value Rule Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.
Net Present Value 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?

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