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DISCOUNTEDCASHFLOWAPPLICATIONS
INSTRUCTOR SLIDES
QUANTITATIVEMETHODS
Net Present Value
The net present value (NPV) of an investment equals the present value of all expected
inflows from the investment minus the present value of all expected outflows.
The rate used to discount the cash flows is the appropriate cost of capital, which
o Reflects the opportunity cost of undertaking the particular investment
o Compensates investors for various risks inherent in the investment
o Assumes that all cash flows from the project will be reinvested at the cost of capital.
Calculation
1. Identify all cash inflows and outflows associated with the investment.
2. Determine the appropriate discount rate.
3. Compute the PV of all cash flows.
4. Aggregate all the present values, with inflows as positive values, and outflows as
negative values.
2
t 1 2
0
1 1 t
CF CF CF
NPV =CF + + +.... +
1 +r 1 +r 1 +r
Net Present Value
The NPV Rule
1. Positive NPV projects increase shareholder wealth and should be accepted.
2. Negative NPV projects decrease shareholder wealth and should be rejected.
3. For mutually exclusive projects the project with the highest, positive NPV should be
chosen as it would add the most value to the firm.
3
Net Present Value
Example: Applying the NPV Rule
ABC Corporation is preparing a feasibility study for a project that has an initial cost of $8
million. It will generate no cash flows in the first year. However, the project will generate
positive cash flows of $2 million at the end of the second year, $3.2 million at the end of
third year and $3.3 million at the end of fourth year. Assume that the discount rate is 12%.
Calculate the NPV of the project and determine whether the company should invest in it.
Solution
NPV =-$8 +$0 +$1.594 +$2.277 +$2.097
NPV =-$2.030706 million
The company should NOT pursue the project because it has a negative NPV.
4
2 3 4
$2 $3.2 $3.33
NPV = $8 +$0 + + +
1.12 1.12 1.12