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Unformatted text preview: 9 Net Present Value and Other Net Investment Criteria Investment 1 Key Concepts and Skills Be able to compute payback and discounted Be payback and understand their shortcomings payback Understand accounting rates of return and their Understand shortcomings shortcomings Be able to compute the internal rate of return and Be understand its strengths and weaknesses understand Be able to compute the net present value and Be understand why it is the best decision criterion understand 2 Chapter Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting 3 Good Decision Criteria We need to ask ourselves the following We questions when evaluating capital budgeting decision rules budgeting Does the decision rule adjust for the time Does value of money? value Does the decision rule adjust for risk? Does the decision rule provide information on Does whether we are creating value for the firm? whether 4 Project Example Information You are looking at a new project and you have You estimated the following cash flows: estimated Year 0: CF = -165,000 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 is Your 12%. 12%. 5 Net Present Value The difference between the market value of a The project and its cost project How much value is created from undertaking an How investment? investment? The first step is to estimate the expected future cash The flows. flows. The second step is to estimate the required return for The projects of this risk level. projects The third step is to find the present value of the cash The flows and subtract the initial investment. flows 6 NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is positive expected to add value to the firm and will therefore increase the wealth of the owners. therefore Since our goal is to increase owner weal...
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