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Unformatted text preview: Review of the Basics â€“ NPV and Rate of Return Present Value â€¢ Time Value of Money: â–« A dollar today is worth more than a dollar tomorrow. â€¢ Discount Rate â€“ r â–« Also called: the hurdle rate or the opportunity cost of capital â–« Defined as: Interest rate used to compute present values of future cash flows â€¢ Discount Factor â€“ â€¢ Present Value (PV) = discount factor * C 1 r + 1 1 Net Present Value â€¢ Net Present Value (NPV) â–« Defined as the present value of cash flows minus required investments â–« NPV = r C C + + 1 1 Risk and Present Value â€¢ Not all investments are equally risky. â€¢ Choose a discount factor comparable to the risk of a project. â€¢ Higher risk projects imply higher required rates of return â–« Consider a project that has an initial requirement of $380. The payoff after the first time period is $420. â–« What is the NPV if the discount rate is 5%? NPV = 380 + 420 / 1.05 = 380 + 400 = 20 â–« 12%? NPV = 380 +420 / 1.12 = 380 + 375 = 5 Rate of Return Rule â€¢ Rule: Accept investments that offer rates of return in excess of their opportunity cost of capital â€¢ 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? â–« Return = profit / investment â–« Return = (420 â€“ 370) / 370 = .135 or 13.5% â–« 13.5% > 12%. We should accept the project Net Present Value Rule â€¢ Rule: Accept investments that have positive net present value....
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This note was uploaded on 02/17/2012 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.
 Spring '08
 Staff
 Interest

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