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Internal Rate of Return Discounted cash flow methods enable us to capture differences in the timing of cash flows for various projects through the discounting process. In addition, through our choices of discount rate, we can also account for project risk. One of the discounted cash flow methods is the Net Present Value (NPV). Net Present Value (NPV) is a discounted cash flow approach to capital budgeting.The NPV of an investment proposal is the present value of the proposal's net cash flows less the proposal's initial cash outflow. In the formula form we have
EXAMPLE 1 An investment with an initial cash out flow of $100,000 pays back $34,432 in the first year, $39,530 in the second year, $39,359 in the third year, and $32,219 in the fourth year. If the rate of return is 12%, find the Net Present Value (NPV) SOLUTION
Acceptance Criterion: If the investment project's net present value is zero or more, the project is accepted; if not, it is rejected. Another way to express the acceptance criterion is to say that the project will be accepted if the present value of cash inflows exceeds the present value of cash outflows. |
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Using MS Excel to compute Net Present Value
Syntax NPV(rate,value1,value2, ...) Rate is the rate of discount over the length of one
period. Value1, value2, ... are 1 to 29 arguments representing
the payments and income.
Remarks
Examples Suppose you're considering an investment in which you pay $10,000 one
year from today and receive an annual income of $3,000, $4,200, and $6,800 in
the three years that follow. Assuming an annual discount rate of 10 percent,
the net present value of this investment is: In the preceding example, you include the initial $10,000 cost as one
of the values, because the payment occurs at the end of the first period. Consider an investment that starts at the beginning of the first
period. Suppose you're interested in buying a shoe store. The cost of the
business is $40,000, and you expect to receive the following income for the
first five years of operation: $8,000, $9,200, $10,000, $12,000, and $14,500.
The annual discount rate is 8 percent. This might represent the rate of
inflation or the interest rate of a competing investment. If the cost and income figures from the shoe store are entered in B1
through B6 respectively, then net present value of the shoe store investment is
given by: In the preceding example, you don't include the initial $40,000 cost
as one of the values, because the payment occurs at the beginning of the first
period. Suppose your shoe store's roof collapses during the sixth year and you
assume a loss of $9000 for that year. The net present value of the shoe store
investment after six years is given by:
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