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Cost of capital
The required annual rate of return on an investment project aka discount rate, required rate of return, hurdle rate
NPV
Present value of the cash inflows mins the present value of the cash outflows
NPV decision rule
If the NPV is >= 0 then accepting the project will increase the wealth of the shareholders
Project cashflow assumptions for our purposes
NPV is based on cash flows
Project cash flows occur annually.
Projects usually begin with a cash outflow at year 0
(t=0)
Decision rule: Mutually exclusive projects
often businesses have multiple investment projects available to them but are only able to proceed with one of them
eg a business may be looking to open new stores and they have a choice between location A and location B
in this case the projects are mutually exclusive and the project with the highest NPV is chosen
NPV: timing decision
Sometimes businesses may have flexibility regarding the timing of an investment decision
eg upgrading systems at any point in time
regardless of when the project starts all projects must be discounted back to PV to ensure they are commensurate(fair comparison)
decision rule: choose the option with the highest NPV( at year 0)
NPV: choice of equipment
often businesses require new equipment but have a range of options in terms of what they can buy
as a decision rule choose the option with lowest EAA
Basic NPV calculation
EAC formula
EAC = NPV/annuity factor
