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Unformatted text preview: ds the present value of the costs. As a result, the value of the
firm increases and investors are wealthier. Projects with negative NPVs have costs that
exceed their benefits. Accepting them is equivalent to losing money today.
We capture this logic in the NPV decision rule:
When choosing among investment alternatives, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.
Because NPV is expressed in terms of cash today, using the NPV decision rule is a
simple way to apply the Valuation Principle. Decisions that increase wealth are superior
to those that decrease wealth. We don’t need to know anything about the investor’s
preferences to reach this conclusion. As long as we have correctly captured all of the
cash flows of a project, being wealthier increases our options and makes us better off,
whatever our preferences are.
We now look at some common ways the NPV decision rule is applied in practice.
Accepting or Rejecting a Project. A common financial decision is whether to accept or
reject a project. Because rejecting the project generally has NPV 0 (there are no new costs
or benefits from not doing the project), the NPV decision rule implies that we should ◗ accept positive-NPV projects, because accepting them is equivalent to receiving
their NPV in cash today, and
◗ reject negati...
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This note was uploaded on 02/07/2014 for the course MIS 304 taught by Professor Mejias during the Spring '07 term at University of Arizona- Tucson.
- Spring '07