Corporate Finance

Mahlaqa Jehanzeb
Lecturer, Department of Management Sciences Email: Mahlaqa@comsats.edu.pk

NET PRESENT VALUE

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Learning Objectives
Be able to compute the Net Present Value (NPV) and understand why it is the best decision criterion.

Good Decision Criteria

We need to ask ourselves the following questions when evaluating capital budgeting decision rules:

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?

Net Present Value

The difference between the market value of a project

and its cost How much value is created from undertaking an investment?

The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.

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.

Since our goal is to increase owner wealth,

NPV is a direct measure of how well this project will meet our goal.

Net Present Value

The net present value (NPV) is the difference

between the present value of the cash flows (the benefit) and the cost of the investment (IO):

NPV = PVCF - IO

In other words, this is the increase in wealth that the shareholders will receive if the project is accepted All projects with NPV greater than or equal to zero should be accepted
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The NPV: An Example 1

NPV Calculation
0

9%

-$1,500

$450

$460

$470

$480

$490

$412.84 $387.17 $362.93 $340.04 $318.47 $ 321.45 = Net Present Value

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The NPV: An Example 2

NPV Calculation
0 9% 1 -$3,000 $755 2 3 4 5

$855

$955

$1,054 $1,150

$692.66 $719.64 $737.44 $746.68 $747.42 $ 643.83 = Net Present Value

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Test Example
We will use the following example to demonstrate

the techniques of capital budgeting Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline:
-10,000 2000 2500 3000 3500 4000

If your required return is 12%, should this machine be purchased?

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Good luck

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