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Slide 9 NPV

# Slide 9 NPV - Net Present Value and Other Investment...

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Net Present Value and Other Investment Criteria

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Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index
Good Decision Criteria – A TEST If you decide whether to invest in a project, you need to evaluate 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?

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Net Present Value (NPV) NPV = Present Value minus Cost Computation: Present Value = Just discounted future flows at some discount rate (Present Value Model) Or NPV depends on The expected future cash flows (estimated) The required return for projects of this risk The Cost So, the main task (PV) has been done
Present Value – A Quick Look From what we learnt in PV method for single cash flow and multiple cash flows, calculations become fairly easy t r FV PV ) 1 ( + = n t n t t r c r c r c V ) 1 ( ...... ) 1 ( ) 1 ( P 2 1 2 1 + + + + + + = n n r c r c r c V ) 1 ( ...... ) 1 ( ) 1 ( P 2 2 1 1 + + + + + + =

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Example You are reviewing a new project and have estimated the following cash flows: Year 0: CF = -165,000 (Cost you have to pay) 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%.
NPV – Decision Rule 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 Or with your required return, you are better off as you make positive “profit” Your goal is to increase owner wealth NPV is a direct measure of how well this project will meet your goal goal.

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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 Do we accept or reject the project?
Decision Criteria Test - NPV Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value?

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Slide 9 NPV - Net Present Value and Other Investment...

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