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11S.05._NPV_and_other_Investment_Decisions

11S.05._NPV_and_other_Investment_Decisions - FIN 600...

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FIN 600 – Lecture 5 NPV and other investment criteria Dr. Zhipeng (Alan) Yan
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Key Concepts and Skills Be able to compute payback and discounted payback and understand their shortcomings Be able to compute the internal rate of return and profitability index, understanding the strengths and weaknesses of both approaches Be able to compute net present value and understand why it is the best decision criterion
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Chapter Outline 5.1 Why Use Net Present Value? 5.2 The Payback Period Method 5.3 The Discounted Payback Period Method 5.4 The Internal Rate of Return 5.5 Problems with the IRR Approach 5.6 The Profitability Index 5.7 The Practice of Capital Budgeting
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5.1 Why Use Net Present Value? Accepting positive NPV projects benefits shareholders. 9 NPV uses cash flows 9 NPV uses all the cash flows of the project 9 NPV discounts the cash flows properly
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The Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF’s + Initial Investment Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs Discount rate: Opportunity Cost of Capital - Expected rate of return given up by investing in a project Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV
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Net Present Value – a formula NPV C C r C r C r t t = + + + + + + + 0 1 1 2 2 1 1 1 ( ) ( ) ... ( ) C = Cash Flow t = time period of the investment r = “opportunity cost of capital”(discount rate) The Cash Flow could be positive or negative at any time period.
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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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