FIN 300 Chapter Notes - Chapter 9: Net Income, Discounted Cash Flow, Net Present Value
28 Jun 2018
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FIN – Chapter 9 – Net Present Value and other investment criteria
Capital budgeting is about trying to determine whether a proposed investment or project will
be worth more that its cost
Net present value (NPV) – the difference between an investment’s market value and its cost
If NPV is negative the effect on share value will be unfavourable (NPV rule)
Estimate NPV – first try to estimate the future cash flows the business is expected to produce,
then apply basic discounted cash flow procedure to estimate present value of those cash flows.
Then estimate NPV as the difference between the present value of the future cash flows and
the cost of the investment
Discounted cash flow (DCF) valuation – the process of valuing an investment by
discounting its future cash flows
The pay back is the length of time it takes to recover the initial investment
Payback period – the amount of time required for an investment to generate cash flows
sufficient to recover its initial cost
Based on the payback rule, an investment is acceptable if its calculated payback period
is less than some prespecified number of years
Short comings:
oWe calculate the payback period by simply adding up the future cash flows,
there is no discounting involved, so the time value of money is completely
ignored
By ignoring time value of money we may be led to take investments that
actually are worth less than they cost
oAlso fails to consider any risk differences (payback calculated the safe for very
risky and safe projects)
oIgnoring cash flows beyond the cut off, we may be le to reject profitable long
term investment
Using a payback period rule will tend to bias us toward shorter-term investments
oBecause its bias toward short term projects, its bias toward liquidity (frees up
cash for other uses quickly)
Discounted payback period – the length of time required for an investment’s discounted cash
flows to equal its initial cost
Based on the discounted payback rule, an investment is acceptable if its discounted
payback is less than some prespecified number of years
Drawbacks:
oThe cut off still has to be arbitrarily set and cash flows beyond that point are
ignored
oJust because one project has shorter discounted payback doesn't mean it has a
larger NPV
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Fin chapter 9 net present value and other investment criteria. Capital budgeting is about trying to determine whether a proposed investment or project will be worth more that its cost. Net present value (npv) the difference between an investment"s market value and its cost. If npv is negative the effect on share value will be unfavourable (npv rule) Estimate npv first try to estimate the future cash flows the business is expected to produce, then apply basic discounted cash flow procedure to estimate present value of those cash flows. Then estimate npv as the difference between the present value of the future cash flows and the cost of the investment. Discounted cash flow (dcf) valuation the process of valuing an investment by discounting its future cash flows. The pay back is the length of time it takes to recover the initial investment.
