02FinReview_NPV,IRR (1) - RateofReturn PresentValue...

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Review of the Basics – NPV and  Rate of Return
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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
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Net Present Value Net Present Value (NPV) Defined as the present value of cash flows minus  required investments  NPV =  r C C + + 1 1 0
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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
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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
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Net Present Value Rule Rule: Accept investments that have positive net present  value.
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