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Unformatted text preview: 1 Chapter 8: Net Present Value and Other Investment Criteria Capital Budgeting Decision 2 Topics Covered Net Present Value Other Investment Criteria More Examples of Mutually Exclusive Projects Capital Rationing 3 Net Present Value Net Present Value Present value of cash flows minus initial investments. Opportunity Cost of Capital Expected rate of return given up by investing in a project 4 Net Present Value Example Suppose we can invest $50 today & receive $60 later today . What is our increase in value? Initial Investment Added Value $50 $10 Answer: Profit =  $50 + $60 = $10 5 Net Present Value Example Suppose we can invest $50 today and receive $60 in one year . What is our increase in value given a 10% expected return? Profit = 50 + 60 1.10 = $4.55 Initial Investment Added Value $50 $4.55 6 Net Present Value NPV = PV required investment NPV C C r C r C r t t = + + + + + + + 1 1 2 2 1 1 1 ( ) ( ) ... ( ) 7 Net Present Value Terminology C = Cash Flow t = time period of the investment r = opportunity cost of capital The Cash Flow could be positive or negative at any time period. 8 Net Present Value Net Present Value Rule Net Present Value Rule Managers increase shareholders wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value. A hidden assumption: there is no budget constraint or money constraint. 9 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 if the opportunity cost of capital is 7%? 10 10 Net Present Value $16,000 $16,000 $16,000 $450,000 $466,000 0 1 2 3 Present Value 14,953 13,975 380,395 $409,323 Example continued 11 11 Net Present Value Example continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?...
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 Spring '09
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 Net Present Value

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