Julia Mcwilliams Managerial Finance 515 2/2/2023

Net Present Value and Other Investment Criteria

 Difference between projects value and its cost – Net present value
Companies can best help their shareholders by investing in all projects with a positive NPV and
rejecting those with a negative NPV.
Instead of calculating a projects NPV, company’s often compare the expected rate of return
from investing in the project with the return that shareholders could earn on equivalent-risk
investments in the financial market. The company accepts those projects that provide a higher
return than shareholders could earn for themselves.
NPV= C₀ + C₁ + C₂ + … C₀= initial investment
(1+r) (1+r)²

 A firm can either keep cash and reinvest or return cash to its investors
 If cash reinvested, then opportunity cost = expected rate of return that shareholders
could have obtained by investing in financial assets.
 Company calculate the projects internal rate of return (IRR) which is a close relative of
NPV. IRR rule states that the firm should accept an investment project if the opportunity
cost of capital is less than the internal rate of return. If its equal to IRR the project has 0
NPV. If its greater than IRR the project has a -NPV
NPV= C₀ + C₁ + C₂ +…+ Cₐ =0
1 + IRR (1 + IRR)² (1+ IRR)^a

 NPV: 1) recognizes that a dollar today is worth more than a dollar tomorrow. 2) It
depends solely on the forecasted cash flows from the projects and opportunity cost of
capital. Investment rule affected by managers taste, company choice of accounting,
profitability. 3) Because PV measured in todays dollars, you can add them up. So if you
have two projects A and B the net NPV combined is:
NPV (A+B) = NPV (A) + NPV(B)

 Book rate of return= book income / book assets

 Operating expense is deducted immediately from each years income. Capital
Expenditures are put on the firms BS and then depreciated.
 A companys book rate is not a good measure of company true profitability
 Payback period= counting the # of years it takes before the ash flow equals the initial
investment
 Payback rule= project should be accepted if its payback period is less than specified
cutoff period. It ignores all cash flows after cutoff date and gives equal weight to all cash
flows before the cutoff date.

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Julia Mcwilliams Managerial Finance 515 2/2/2023

 Rate of return= payoff / investment - 1 rate of return is discount rate that gives 0 NPV
 NPV= C₀ + C₁ =0
1+ DISCOUNT RATE

Discount rate= C₁ / -C₀ - 1 C₁= payoff, -C₀= required investment

To calculate return when project produces cash flows in several periods