ActSc371_Lecture 15_Chapter 7 (Ross)

ActSc371_Lecture 15_Chapter 7 (Ross) - ActSc 371 Corporate...

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Lecture 15 Sections 7.1-7.3: Net Present Value and Other Investment Rules(Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1
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Introduction A corporate project generating a set of cash flows can be valued by discounting these flows, an approach called the net present value (NPV) approach. We believe that the NPV approach is the best for evaluating capital budgeting projects. There are also other alternative methods: payback Accounting rate of return Internal rate of return Profitability index
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7.1 Why Use Net Present Value The basic investment rule can be generalized to: Accept a project if the NPV is greater than zero. Reflect a project if NPV is less than zero. Formula for NPV: ( 29 ( 29 ( 29 n n r C r C r C r C C NPV + + + + + + + + + = 1 1 1 1 3 3 2 2 1 0
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Example: The Alpha Corporation is considering investing in a riskless project costing $100. The project receives $107 in one year and has no other cash flows. The interest rate is 6 percent. The NPV of the project can easily be calculated as $0.94=-$100+$107/1.06 We know that the project should be accepted since its NV is positive. Had the NPV of the project been negative, as would have been the case with an interest rate greater than 7 percent, the project should be rejected.
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Why does the NPV rule lead to a good decision? Consider the following two statements: 1. Use $100 of corporate cash to invest in the project. The $107 will be paid as a dividend in one year. 2. Forgo the project and pay the $100 of corporate cash as a dividend today.
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