W7 Principles of Finance

Net Present Value (NBV) Decision Rule

Firms measure values in terms of NPV (Terms of cash today)

NPV Calc

NPV = PV (Benefits) - PV (Costs)

NPV Decisions

As long as NPV is positive, the decision increases the value of the firm regardless of current cash needs or preferences

Payback Rule

Calc amount of time it takes to pay back initial investment called "payback period"

Payback Accepted if

Accept if the payback period is less than a pre-specified length of time.

Payback reject if

Reject if the payback period is greater than a pre-specified length of time.

Payback Rule Cons

1. Arbitrary cut off period to sum cash flows 2. No discount future CF (Ignores time value of money) 3. Simply sums cash flows & compares with outflow in present (Ignores cash flows after payback period)

Internal Rate of Return (IRR)

Take any investment opportunity where IRR exceeds opportunity cost of capital

IRR accept

if the cost of capital < IRR;

IRR reject

if the cost of capital > IRR.

Independent Projects

Projects where decision to accept 1 project does not affect decision to accept / reject other projects (Invest in all positive NPV projects)

Mutually Exclusive Projects

Can't pick project with positive NPV, must rank & choose best one & pick project with highest NPV

Crossover Point

The crossover point is the discount rate that makes the NPV of the two alternatives equal.

Equivalent Annual Annuity (EAA)

Method used to evaluate projects with different lives (• The level annual CF with same present value as CF of projects)

Profitability Index

Measures "bang for your buck" value created in terms of NPV per unit of resource consumed

Profitability Index Steps

Start with project of highest index moving down ranking taking all projects until resource consumed