Net Present Value Bobby Strozak Steve Johnson

Net Present Value: Estimates how much a potential project will contribute to shareholder wealth, which is the primary capital budgeting decision criterion

Net Present Value Is equal to the present value of future net cash flows, discounted at the cost of capital After calculating NPV if greater than zero accept because it increases firm’s value by undertaking project. If less than zero reject project because it decrease firm value. Assume the reinvestment rate is the cost of capital

Types of Projects Projects can be Mutually Exclusive or Independent… Mutually Exclusive- compares two possible projects choices and undertakes the one with the greater NPV Independent- Keeps both projects as long as NPV is greater than zero

Specifics Cross Over Rate- The cost of capital for two projects where the NPVs cross thus yielding equal NPVs Timing Differences Project Size

NPV versus IRR The basic difference between NPV and IRR is that the NPV method assumes that the rate of reinvestment is the cost of capital, whereas IRR assumes the rate of reinvestment is the IRR. The best reinvestment rate is the cost of capital, therefore NPV is always preferred to IRR. These methods only differ on mutually exclusive projects.

Why? There are a few pitfalls to IRR, but one of the main ones involves mutually exclusive projects. If project A has a higher IRR than B, but a lower NPV than B, according to IRR, you would accept project A, even though project B creates more firm wealth.

Calculations By Hand 1 2 3 -X A B C +PV of A* +PV of B* +PV of C* 1 2 3 -X A B C +PV of A* +PV of B* +PV of C* NPV of Project * Discount all at the rate of return for project

Calculations cont. On Calculator Use CF button Cf0- Initial outlay(-) C01- Cash flow for year F01- Frequency of cash Flow NPV button than input rate of return given and then compute

Example You are the project manager for an up and coming firm. You are given the option to invest in two projects on a mutually exclusive basis. Using the following information and a rate of return of 10% which project would you choose? Cash Flows Year Project 1 Project 2 0 -1000 -1000 1 500 100 2 400 300 3 300 400

Solution NPV For A -1000 500 400 300 500/1.1 400/(1.1^2) 300/(1.1^3) +454.55 +330.58 +225.39 NPV=10.52

Solution cont. NPV For B -1000 100 300 100/1.1 300/(1.1^2) 400/(1.1^3) +90.91 +247.93 +300.53 NPV=-360.63 400 Based on NPV, Project A should be taken