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BFIN620_PPT_CH7_sp09-10 - 7 1 Business Finance 620 Net...

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7- 1 Net Present Value and Net Present Value and Other Investment Criteria Other Investment Criteria Chapter 7 Brealey-Myers-Marcus 5 th Edition Business Finance 620
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7- 2 Topics Covered Net present value (NPV) Understand why the NPV rule is consistent with the goals of financial management Alternative investment criteria Internal rate of return (IRR) Payback rule Capital rationing and the profitability index Investment timing decisions Equivalent annual cost Assets with different lives Asset replacement decisions
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7- 3 Investment Project Analysis To determine whether an investment project makes sense financially, we need to know: the benefits of the project, and the costs of the project. Do the benefits outweigh the costs? A simple question often requiring a good deal of analysis to reach an answer
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7- 4 Net Present Value Basic Illustration You 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 $ 1.10 60 + 50 - Costs Benefits = Profit = = - Initial Investment Added Value $50 $4.55 The $4.55 added value is the NPV of this one-year investment – Your profit in today’s dollars.
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7- 5 Net Present Value Formula Net 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 C i is a project’s i th cash 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. N N 2 2 1 0 R) (1 C ... R) (1 C R) (1 C C NPV + + + + + + + =
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7- 6 Net Present Value Decision Rule Net Present Value Rule Accept all 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.
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7- 7 A Cost Savings Project NPV Application Possible costs to consider: Costs resulting from running the project Costs paid regardless of whether the project runs The benefits of the project After-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).
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