Net Present Value (NPV) = ﹣Initial Investment + Total PV of future CF’s
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NPV – Decision Rule
If the NPV is positive, accept the project
A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
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Net Present Value
The difference between the market value of a project and its cost.
NPV, 75%
IRR, 76%
Payback, 57%
Book rate of return, 20%
Profitability Index, 12%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.
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Payback
The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.
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CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques
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NPV – Decision Rule
Minimum Acceptance Criteria: Accept if NPV >0
Ranking Criteria: Choose the highest NPV
Example9.1 see page263
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Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
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Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating value for the firm?
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Good Decision Criteria
We need to ask ourselves the following questions when evaluating capital budgeting decision rules:
The payback rule says only accept projects that “payback” in the desired time frame.
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NPV – Decision Rule
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate 3. Estimate initial costs
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Corporate Finance
Chapter 9
Why Net Present Value Leads to Better Investment
Decisions than Other Criteria
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Topics Covered
NPV and its Competitors The Payback Period The Average Accounting Return Internal Rate of Return Capital Rationing