study material on finance 49

May 14th, 2015
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Net Present Value (NPV) = Total PV of future CFs - Initial Investment

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Capital BudgetingInvestment RulesFinance - Pedro Barroso1Net Present Value (NPV) Rule Net Present Value (NPV) =Total PV of future CFs - Initial Investment Estimating NPV:1. Estimate future cash flows: how much? and when?2. Estimate discount rate: time value of money; risk3. Estimate initial costs Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPVFinance - Pedro Barroso2Why Use Net Present Value? Accepting positive NPV projects benefitsshareholdersNPV uses cash flowsNPV discounts the cash flows properlyMaximizes shareholder value (stock price) Reinvestment assumption: NPV rule assumesthat all cash flows can be reinvested at thediscount rateFinance - Pedro Barroso3Example: Project Using previous example and discount rate of 10%:34 ,680 49,990 82,893 69,634 219,421NPV 260,000 234(1.1)(1.1)(1.1)(1.1)(1.1)5NPV 58,924Micros oft OfficeExcel 97-2003 Works heet NPV > 0: go-on with projectFinance - Pedro Barroso4Payback Period Rule How long does it take the project to payback its initial investment? Payback Period = number of years to recoverinitial costs Minimum Acceptance Criteria: Set by management Ranking Criteria: Set by managementFinance - Pedro Barroso5Problems with Payback Period Ignores the time value of money Ignores cash flows after the payback period(biased against lon

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