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Net Present Value (NPV) - Capital Budgeting The essence of corporate financial management (and your job as a financial manager) is to create value for the shareholders. Value? By value we mean an investment that has more value than what it costs to purchase or build. Take this example. Say we buy a broken down house for $100,000. We spend $35,000 for major repairs and upgrades. The total cost adds up to $135,000 right? Now what if the value of the house in the market was $160,000? This means we've created a value of $160,000 - $135,000 = $25000 The challenge of financial management comes when you have to determine beforehand that the $35000 repairs and upgrades you've done on the property will actually net you a positive return. How do you distinguish from good and bad investments? This is called capital budgeting and the difference between an investment's cost and its value is called the Net Present Value (NPV). How do you Calculate Net Present Value (NPV)? You calculate NPV by combining the initial investment with the annual cash flows and the expected # of years the cash flows are expected to be produced for. An example would best prove this: Q: XYZ Corporation has $25000 to invest. The following alternative investments and their annual cash flows are presented. The company's required rate of return is 8.3% interest compounded monthly. Which investment would you (as a financial manager) pick? Why? Notes: CFO = Initial Investment and is always entered as a negative (since the company is paying out the money). E.g an initial investment of $-10,000 means the company paid out that amount. CO1 = Cash flow (in) for Year 1
In order to perform this calculation, we are going to use the BAII Plus Financial Calculator. Investment A In your calculator, type in 2nd -> CF CFO = -10,000 CPT -> NPV I = 8.3% (this is the company's required rate of return) NPV -> CPT = -$6699.30 Investment B In your calculator, type in 2nd -> CF CFO = -10,000 CPT -> NPV I = 8.3% (this is the company's required rate of return) NPV -> CPT = -$5698.90 Can you follow these steps to discount the cash flows for each of the Investments from C to F? If you do, you should get the following answers:
The rules of NPV? - If an investment has a Positive NPV,
then go ahead and do it! From the above investments ranging from A to F, which one would you go ahead and invest in? Solution: Considering the rules of NPV, pick investment E because it is the only one that has a POSITIVE Net Present Value (NPV) of $6405. The rest all bring in NEGATIVE NPVs.
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