Chapter_9_FI311_FA2011_SS

Chapter_9_FI311_FA2011_SS - Click to edit Master title...

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Unformatted text preview: Click to edit Master title style 12/29/11 1 12/29/11 Chapter 9 Net Present Value and Other Investment Criteria Click to edit Master title style 12/29/11 2 12/29/11 Key Concepts and Skills Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute internal rates of return (standard and modified) and understand their strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion Be able to compute the profitability index and understand its relation to net present value Click to edit Master title style 12/29/11 3 12/29/11 Good Decision Criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rules: Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? Click to edit Master title style 12/29/11 4 12/29/11 Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. NPV = ( PV _ Future _ CF )- ( Initial _ Investment ) Click to edit Master title style 12/29/11 5 12/29/11 Project Example Information You are reviewing a new project and have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 Your required return for assets of this risk level is 12%. Click to edit Master title style 12/29/11 6 12/29/11 NPV Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. Click to edit Master title style 12/29/11 7 12/29/11 Computing NPV for the Project Using the formulas: NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 = 12,627.41 Using the calculator: CF = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41 Do we accept or reject the project? Click to edit Master title style 12/29/11 8 12/29/11 Decision Criteria Test - NPV Does the NPV rule account for the time value of money?...
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This note was uploaded on 12/28/2011 for the course FI 311 taught by Professor Booth during the Fall '06 term at Michigan State University.

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Chapter_9_FI311_FA2011_SS - Click to edit Master title...

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