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Closing the Business Case Prof. John-Paul Clarke 16.886 Air Transportation Systems Architecting April 21, 2004

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The top 5 investor questions How much will I need to invest? How much will I get back? When will I get my money back? How much is this going to cost me? How are you handling risk & uncertainty?
Investment criteria Net present value •P a y b a c k Discounted payback Average return on book value Internal rate of return

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Net present value (NPV) Measure of present value of various cash flows in different periods in the future Cash flow in any given period discounted by the value of a dollar today at that point in the future – “Time is money” – A dollar tomorrow is worth less today since if properly invested, a dollar today would be worth more tomorrow Rate at which future cash flows are discounted is determined by the “discount rate” or “hurdle rate” – Discount rate is equal to the amount of interest the investor could earn in a single time period (usually a year) if he/she were to invest in a “safer” investment
Calculating NPV Forecast the cash flows of the project over Its economic life – Treat investments as negative cash flow Determine the appropriate opportunity cost of capital Use opportunity cost of capital to discount the future cash flow of the project Sum the discounted cash flows to get the net present value (NPV) NPV = C 0 + C 1 1 + r + C 2 1 + r () 2 + K + C T 1 + r T

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NPV example Period Discount Factor Cash Flow Present Value 0 1 -150,000 -150,000 1 0.935 -100,000 -93,500 2 0.873 +300000 +261,000 Discount rate = 7% NPV = \$18,400
Points to keep in mind about NPV Assumes only one course of action: – Reasonable assumption if conditions are stable – No room for managerial flexibility Choice of the discount rate is difficult: – Typically, use a combination of equilibrium models (like CAPM) and “expert judgment” – Should always perform sensitivity analysis on discount rate!

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Payback
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