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Unformatted text preview: Net Present Value and Other Investment Criteria Capital budgeting decisions are based on the following criterias: a) Net present value b) The payback period c) The discounted payback period d) The average accounting return e) The internal rate of return g) The pro…tability index A) The Net present value: A manager that is trying to use the net present value criteria in making capital budgeting decisions is making decisions which maximizes the current price of the …rm’s common stock Consider an investment in an asset (say price of a real estate) for a price of $2000. Assume that the asset can be sold for $2500 one year from today. Alternatively the investor has an opportunity to earn an 8% rate of return on an investment of similar risk. To decide whether to acquire the asset or not, we could use the future value concept, the present value concept or the rate or return concept. Say we are using the future value concept. If the investor invests the $2000 at 8% for one year, or he can invest the $2000 to acquire the real estate today. If he selects the …rst option, then in one year, he will receive: FV = PV £ (1 + r) = $2000 £ (1 + 0.08) = $2160 clearly the second alternative is better since the investor will have $2500 rather than $2160 one year from today. Therefore the investor should acquire the real estate today for $2000. The investor can also use the present value concept to evaluate the investment opportunity. He could say: at the 8% opportunity cost, what deposit would he have to make today in order to receive a return (future value ) of $2500 on year from today. Using the present value concept: PV = FV/(1 + r) = $2500/(1+0.08) = $2314.81 That is greater than the cost of the real estate at the beginning ( which is $2000). So it is better to acquire the real estate. The present value approach to investment decisionmaking can also be described in terms of the di¤erence between the present value of the investment ($2314.81) and the cost of the investment ($2000). 1 This di¤erence is called the Net Present Value. So for our example: NPV = PV  Cost = $2314.81  $2000 = $314.81. Note that the investor could sell the real estate for $2314.81 immediately after purchasing it. That amount ($2314.81) represents the market value of the asset. Thus the net present value (NPV) is the di¤erence between an investment’s market value and its cost. An investment with a positive net present value provides a net bene…t to the investor equal to the net present value; an investment with a negative net present value is unacceptable. a) Estimating the Net Present Value: Say a company is considering the acquisition of new construction equipment. The estimate for the cost to acquire the equipment is $10000. It is estimated that the company’s cash revenues will increase by $9000 for each of the next two years. However cash expenses will increase by $4000 each year. ( cost include among other costs, labor costs, income taxes. they do not include depreciation, which is not ainclude among other costs, labor costs, income taxes....
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 Spring '10
 CHISHOLM
 Net Present Value, cash ‡ows

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