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0Chapter8NetPresentValueandOtherInvestmentCriteria
1KeyConceptsandSkillsUnderstandthepaybackruleanditsingsUnderstandaccountingratesofreturnandtheirproblemsUnderstandtheinternalrateofreturnanditsstrengthsandweaknessesUnderstandthenetpresentvalueruleandwhyitisthebestdecisioncriteria
2ChapterOutlineNetPresentValueThePaybackRuleTheAverageAccountingReturnTheInternalRateofReturnTheProfitabilityIndexThePracticeofCapitalBudgeting
3GoodDecisionCriteriaWeneedtoaskourselvesthefollowingquestionswhenevaluatingdecisioncriteriaDoesthedecisionruleadjustforthetimevalueofmoney?Doesthedecisionruleadjustforrisk?Doesthedecisionruleprovideinformationonwhetherwearecreatingvalueforthefirm?
4ProjectExampleInformationYouarelookingatanewprojectandyouhaveestimatedthefollowingcashflows:Year0: CF=-165,000Year1: CF=63,120;NI=13,620Year2: CF=70,800;NI=3,300Year3: CF=91,080;NI=29,100AverageBookValue=72,000Yourrequiredreturnforassetsofthisriskis12%.
5NetPresentValueThedifferencebetweenthemarketvalueofaprojectanditscostHowmuchvalueiscreatedfromundertakinganinvestment?Thefirststepistoestimatetheexpectedfuturecashflows.Thesecondstepistoestimatetherequiredreturnforprojectsofthisrisklevel.Thethirdstepistofindthepresentvalueofthecashflowsandsubtracttheinitialinvestment.
6NPVDecisionRuleIftheNPVispositive,accepttheprojectApositiveNPVmeansthattheprojectisexpectedtoaddvaluetothefirmandwillthereforeincreasethewealthoftheowners.Sinceourgoalistoincreaseownerwealth,NPVisadirectmeasureofhowwellthisprojectwillmeetourgoal.
7ComputingNPVfortheProjectUsingtheformulas:NPV=63,120/(1.12)+70,800/(1.12)2+91,080/(1.12)3–165,000=$12,627.41Usingthecalculator:CF0=-165,000;C01=63,120;F01=1;C02=70,800;F02=1;C03=91,080;F03=
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