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Unformatted text preview: Review of the Basics NPV and Rate of Return Present Value Time Value of Money: A dollar today is worth more than a dollar tomorrow. Discount Rate r Also called: the hurdle rate or the opportunity cost of capital Defined as: Interest rate used to compute present values of future cash flows Discount Factor Present Value (PV) = discount factor * C 1 r + 1 1 Net Present Value Net Present Value (NPV) Defined as the present value of cash flows minus required investments NPV = r C C + + 1 1 Risk and Present Value Not all investments are equally risky. Choose a discount factor comparable to the risk of a project. Higher risk projects imply higher required rates of return Consider a project that has an initial requirement of $380. The payoff after the first time period is $420. What is the NPV if the discount rate is 5%? NPV = 380 + 420 / 1.05 = 380 + 400 = 20 12%? NPV = 380 +420 / 1.12 = 380 + 375 = 5 Rate of Return Rule Rule: Accept investments that offer rates of return in excess of their opportunity cost of capital Ex: A project requires an initial investment of $370. The expected payoff after one year is $420. If the foregone investment opportunity is 12%, according to the rate of return rule should we invest in this project? Return = profit / investment Return = (420 370) / 370 = .135 or 13.5% 13.5% > 12%. We should accept the project Net Present Value Rule Rule: Accept investments that have positive net present value....
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 Spring '08
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