Chapter 7 Slides

Chapter 7 Slides - 7-1Finance 37Chapter Seven Net Present...

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Unformatted text preview: 7-1Finance 37Chapter Seven Net Present Value and Other Investment Criteria7-2Finance 3Topics CoveredNet Present ValueOther Investment Criteria–IRRProject Interactions–Mutually Exclusive Projects–Investment Timing–Long-Lived vs. Short-Lived Equipment–Replacing an Old Machine–Pitfalls of IRRCapital RationingSummary7-3Finance 3Net Present ValueThe Net Present Valueof an investment opportunity is the present value of cash flows generated by the investment minus the cost of the initial investment required to get the project started.∑=++=NtttrCCNPV1)1(WhereCtis the cash flow at time tNis the maturity of the projectris the opportunity cost of capital7-4Finance 3NPV exampleYour firm can buy a machine for $50,000 that will generate cash flows of $1,000 per month for the next 60 months. Your cost of capital is 12% APR. Should you buy it?NOCF1F1CF060$1,000−$50,000I1–$5,044.96NPV7-5Finance 3Opportunity Cost of CapitalThe correct discount rate to use in NPV calculations is your opportunity costof capital.The opportunity cost of funds is the return on your next-best available investment opportunity.Don’t confuse opportunity cost with your accounting cost of capital.It’s all about the uses of funds, not the sources of funds.7-6Finance 3A tricky question.Your bank will loan you $1,000,000 for one year at 7%. You have a one-year investment opportunity that returns 9%. Should you undertake this opportunity?a)Yesb) Maybec)NoThe right answer is “Maybe”. If you have an alternative investment that returns 10% you surely would not take the 9% opportunity. If those were your only two opportunities, your opportunity cost of capital would be 9%--not the accounting cost of capital of 7%.7-7Finance 3IRRThe discount rate that sets the NPV of the project to zero.Offers an easy-to-communicate project summary.7-8Finance 3Calculating Internal Rate of ReturnExampleYou can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the firstthree years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?0 350 00016 000116 0001466 0001123= - ++++++,,( ),( ),( )IRR IRR IRRIRR = 12.96%7-9Finance 3Internal Rate of ReturnCalculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. –350,00016,0002466,000IRRCF1F1CF0CF212.96%7-10Finance 3IRR and NPV Payoff Profile-200-150-100-50501001502005101520253035Discount rate (%)NPV (,000s)IRR=12.96%IRR is the discount rate that gives you a zero NPV7-11Finance 3Internal Rate of ReturnExampleYou have two proposals to choose between. The initial proposal (A) has a cash flow that is different than the revised proposal (B)....
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This note was uploaded on 04/07/2008 for the course HIST 101 taught by Professor Wormer during the Spring '08 term at Missouri (Mizzou).

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Chapter 7 Slides - 7-1Finance 37Chapter Seven Net Present...

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