136
Business Finance (ACC501)
Lesson 26
Review of the Previous Lecture
•
Preferred Stock Features
•
The Stock Market
•
Net Present Value
–
Estimating NPV
Topics under Discussion
•
Net Present Value
–
Using NPV
•
The Payback Rule
•
Average Accounting Return
Using NPV
•
Given that the goal of financial management is to increase the share value, we have
the net present value rule
“
An investment should be accepted if the net present value is positive and
rejected if it is negative.”
•
In the unlikely event that NPV is turned out to be zero, we would be indifferent
between taking and not taking the investment
•
Two comments
–
The task of coming up with cash flows and the discount rate is much more
important than the process of discounting itself.
–
The process of discounting cash flows would only give us an estimated figure of
NPV. The true NPV can be found by putting the investment for sale and see
what we got for it.
•
Suppose we are asked to decide whether or not a new product be launched.
–
Based on projected costs and sales, we expect that the cash flows over the 5-year
life of the project will be $2,000 in first two years, $4,000 in the next two and
$5,000 in the last year.
–
It would cost about $10,000
to begin production.
–
Given a 10% discount rate, what should we do?
•
The total value of the product by discounting its cash flow to present:
PV = $2,000/1.1 + 2,000/1.1
2
+ 4,000/1.1
3
+ 4,000/1.1
4
+
5,000/1.1
5
= $1,818 + 1,653 + 3,005 + 2,732 + 3,105
= $12,313
•
The present value of the expected cash flows is $12,313, but the cost of getting those
cash flows is $10,000 so the NPV is $12,313 – 10,000 = $2,313