BFIN620_PPT_CH7_sp09-10

BFIN620_PPT_CH7_sp09-10 - 7- 1Net Present Value andNet...

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Unformatted text preview: 7- 1Net Present Value andNet Present Value andOther Investment CriteriaOther Investment CriteriaChapter 7Brealey-Myers-Marcus5thEditionBusiness Finance 6207- 2Topics CoveredNet present value (NPV)Understand why the NPV rule is consistent with the goals of financial managementAlternative investment criteriaInternal rate of return (IRR)Payback ruleCapital rationing and the profitability indexInvestment timing decisionsEquivalent annual costAssets with different livesAsset replacement decisions7- 3Investment Project AnalysisTo determine whether an investment project makes sense financially, we need to know:the benefits of the project, andthe costs of the project.Do the benefits outweigh the costs?A simple question often requiring a good deal of analysis to reach an answer7- 4Net Present ValueBasic IllustrationYou invest $50 today and will receive $60 in one year.The benefit is the $60 payoff.The cost is the $50 payment today.Your expected (desired) rate of return is 10%.55.4$1.1060+50-CostsBenefits=Profit==-Initial InvestmentAdded Value$50$4.55The $4.55 added value is the NPV of this one-year investment – Your profit in today’s dollars.7- 5Net Present Value FormulaNet Present Value (NPV)The difference between the PV of a project’s future after-tax cash flows and the project’s initial cost.General formula for NPV:where Ciis a project’s ithcash flow (may be positive or negative), N is the length of the project in time periods, and R is the project’s required rate of return. NN221R)(1C...R)(1CR)(1CCNPV+++++++=7- 6Net Present ValueDecision RuleNet Present Value RuleAcceptall projects with a positive net present value. Reject all other projects.WHY?The goal of financial managers is to increase the wealth of shareholders.Managers should accept all projects worth more than their cost.Only projects with a positive NPV “add value” to shareholder wealth.7- 7A Cost Savings ProjectNPV ApplicationPossible costs to consider:Costs resulting from running the projectCosts paid regardless of whether the project runsThe benefits of the projectAfter-tax savings of $50,000 at the end of Year 1.These first-year savings will growth at 2% per year for the next two years (2 and 3), remaining constant for Year 4 (at the Year 3 level).Plans call for the project to run 4 years.The appropriate discount rate is 12%.Should the project be undertaken?7- 8A Cost Savings ProjectNPV Application PeriodCash FlowPV of Cash Flow1$ 50,00044,643 = 50,000 / 1.12251,000= 50,000 (1.02)40,657 = 51,000 / (1.12)2352,020= 50,000 (1.02)237,027 = 52,020 / (1.12)3452,020= 50,000 (1.02)233,060 = 52,020 / (1.12)4TOTAL$ 155,387 (PV of cash flows)PROJECT BENEFITS7- 9A Cost Savings ProjectNPV Application...
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This note was uploaded on 10/10/2011 for the course BUSINESS 620 taught by Professor Paul during the Spring '11 term at Ohio State.

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BFIN620_PPT_CH7_sp09-10 - 7- 1Net Present Value andNet...

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