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 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 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
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## This note was uploaded on 12/07/2010 for the course FIN 331 taught by Professor Markmcdaniel during the Spring '10 term at Shawnee.

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

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