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28 Evaluation of Long-Term Projects Analytics for Managerial Decision Making 5. Evaluation of Long-Term Projects
Now that you have learned some basic principles about how dollars are impacted by compound
interest and present value calculations, let’s see how you can use these tools to make better business
decisions. There are a number of alternative methods for evaluating capital budgeting decisions.
These include net present value, accounting rate of return, internal rate of return, and payback. 5.1 Net Present Value
The net present value (NPV) method offsets the present value of an investment’s cash inflows
against the present value of the cash outflows. Present value amounts are computed using a firm’s
assumed cost of capital. The cost of capital is the theoretical cost of capital incurred by a firm. This
cost may be determined by reference to interest rates on debt, or a blending of debt/equity costs. In
the alternative, management may simply adopt a minimum required threshold rate of return that
must be exceeded before an investment will be undertaken. If a prospective investment has a
positive net present value (i.e., the present value of cash inflows exceeds the present value of cash
outflows), then it clears the minimum cost of capital and is deemed to be a suitable undertaking. On
the other hand, if an investment has a negative net present value (i.e., the present value of cash
inflows is less than the present value of cash outflows), the investment opportunity should be
To illustrate NPV, let’s return to our illustration for Markum Real Estate. Assume that the firm’s
cost of capital is 5%. You already know the present value of the cash inflows is $807,828. Let’s
additionally assume that the up-front purchase price for the building is $575,000. $60,000 per year
will be spent on the remodel effort at the end of Year 1 and Year 2. Maintenance, insurance, and
taxes on the building will amount to $10,000...
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