BUSFIN 4211: 2.1 Financial Decision Making

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Business is all about

• making decision

• We need a consistent, structured and rational framework for this decision making

Goal is to only make decisions that

increase firm value

How to make decisions that increase firm value?

• Account for many possible future outcomes (i.e., use expected cash flows)

• Account for time value of money (i.e., measured in terms of dollars today)

• Benchmarked to an alternative (i.e., account for the opportunity cost)

We need the present value to

exceed the costs

By taking into account all cash flows (costs and benefits), we have the following

Net Present Value (NPV)

Net Present Value (NPV) 1

• Def: A method of ranking investment proposals using the NPV, which is equal to the present value of the project’s free cash flows discounted at the cost of capital.

• tells us how much a project contributes to shareholder wealth;

• the larger the NPV, the more value the project adds—and added value means a higher stock price.

Net Present Value NPV 2

• the dollar value added today from taking on a project

For a specific (constant) discount rate r, the NPV measure provides an

unambiguous ranking between difference projects:

Higher NPV is always better!

Invest if and only if

NPV > 0

The discount rate is

• the opportunity cost of capital (or hurdle rate)

  • The expected rate of return on an alternative project of comparable risk

• Capital: Anything that confers value or benefit to its owner, such as a factory and its machinery, intellectual property like patents, or the financial assets of a business or an individual.

Positive NPV projects

increase your wealth today by the amount of the NPV

increase firm value (or shareholder wealth) by the NPV

Negative NPV projects

decrease firm value (or shareholder wealth) by the NPV

Zero NPV project

have no effect on your current wealth

We need the following inputs to calculate NPV of a project:

1) Expected cash flows of the project (present and future)

2) Discount rate (or opportunity cost of capital)

We use expected cash flows as projects are risky –

cash flows are not guaranteed!

The discount rate depends on

the risk of the project

Opportunity cost of capital:

Return on investments with similar risk, maturity

the NPV rule can handle

• any pattern of cash flows!

• Ex. cash outflow first, then cash inflows

Calculating NPV in Excel

• Set up the cash flows in a row

• Calculate the discounted cash flow in each year

Reference the discount rate instead of hard-coding, easier to make changes

• Sum the discounted cash flows to obtain the NPV

Higher discount rate implies

• lower NPV!

• Note: This pattern holds only if cash inflows occur after cash outflows

If projects are not mutually exclusive and the firm is unconstrained:

• Select all projects with positive NPV!

If projects are mutually exclusive, we can only choose one:

• Choose the project with highest NPV!

Reject all

negative NPV projects

Mutually Exclusive

Def: A set of projects where only one can be accepted.

Unconstrained

?