MFIN1021 Chapter Notes - Chapter 8: Cash Flow, Net Present Value, Payback Period
11 Jun 2018
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Chapter 8:
Formulas:
NPV= Cash flow – investment::: C0 + C1/(1+r)+ C2/(1+r)2 + C3/(1+r)3 …
IRR: Profits/ Investment= (Cash flows- investment)/ Investments.
Discounted cash flow rate: IRR=OCC
Profitability index: NPV/Initial Investment
Equivalent annual annuity: PV/ annuity factor
Definitions
OCC: opportunity cost of Capital – returned rate of return given up by investing in a project. ----
The rate of return need for an investor to invest in a project a set risk.
Net Present value- present value of cash flows minus investment.---- all outflows of cash minus
the initial investment.
Discounted cash flow rate: the rate of return that make npv of a project zero. When IRR=OCC
Mutual exclusive: One cannot pick both of the options, one must choose one choice.
Profitability index: Measures the npv of give dollar invested in the project
Capital rationing: a shortage of funds available for investing/ limits set on the amount of funds
available for investment
· Soft: company wants the managers to only invest in the best project, ie could give them more
money back doesn’t.
· Hard: there is no more money left to invest.
Payback period: Time until the cash flows recover the initial investments in the project.
equivalent annual annuity : The cash flow per period with the same present value as the cost
of buying and operating a machine.
Rules:
1. The net present value rule states that managers increase shareholders’ wealth by
accepting projects that are worth more than they cost. Therefore, they should accept all
projects with a positive net present value.
2. A risky dollar is worth less than a safe one.
3. When choosing among mutually exclusive projects, choose the one that offers the
highest net present value.
4. The NPV rule. Invest in any project that has a positive NPV when its cash flows are
discounted at the opportunity cost of capital.
5. The rate of return rule. Invest in any project offering a rate of return that is higher than
the opportunity cost of capital.
6. The rate of return is the discount rate at which NPV equals zero.
7. The discount rate that gives the project a zero NPV is known as the project’s internal
rate of return, or IRR. It is also called the discounted cash-flow (DCF) rate of return.
8. The rate of return rule will give the same answer as the NPV rule as long as the NPV of
a project declines smoothly as the discount rate increases.
find more resources at oneclass.com
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Document Summary
Npv= cash flow investment::: c0 + c1/(1+r)+ c2/(1+r)2 + c3/(1+r)3 . Occ: opportunity cost of capital returned rate of return given up by investing in a project. The rate of return need for an investor to invest in a project a set risk. Net present value- present value of cash flows minus investment. ---- all outflows of cash minus the initial investment. Discounted cash flow rate: the rate of return that make npv of a project zero. Mutual exclusive: one cannot pick both of the options, one must choose one choice. Profitability index: measures the npv of give dollar invested in the project. Capital rationing: a shortage of funds available for investing/ limits set on the amount of funds available for investment. Soft: company wants the managers to only invest in the best project, ie could give them more money back doesn"t. Hard: there is no more money left to invest.
