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Chapter 5: Why NPV leads to better decisions than other criteria.
..
Suppose a manager asks how to decide whether to invest in project X
"First forecast the cash flows generated by project X; second, determine the appropriate
opportunity cost (rate of discount, required rate of return, etc.) that reflects both the time value of
money and the
systematic
risk involved in project X. Third, use this opportunity cost of capital to
discount the future cash flows. Fourth, calculate NPV. Invest in X if NPV > 0."
He asks why.
..
If NPV>0, then investing in X is best for the stockholders
How will positive NPV show up in stock price?
Answer; investors aren't stupid.
..
Where does the discount rate come from?
Answer: look at what the stock market does. From shareholders' point of view, the true
opportunity cost is that we give them back the money--and they then invest it in the market.
Competitors to NPV
•
Payback period--gives equal weight to
all
cash flows, even those far in the future
•
Discounted payback--better, but still short-sighted

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