## Review Of The Basics

Vegetron's chief financial officer (CFO) is wondering how to analyze a proposed \$1 million investment in a new venture called project X. He asks what you think.

Your response should be as follows: "First, forecast the cash flows generated by project X over its economic life. Second, determine the appropriate opportunity cost of capital. This should reflect both the time value of money and the risk involved in project X. Third, use this opportunity cost of capital to discount the future cash flows of project X. The sum of the discounted cash flows is called present value (PV). Fourth, calculate net present value (NPV) by subtracting the \$1 million investment from PV. Invest in project X if its NPV is greater than zero."

However, Vegetron's CFO is unmoved by your sagacity. He asks why NPV is so important.

Your reply: "Let us look at what is best for Vegetron stockholders. They want you to make their Vegetron shares as valuable as possible."

"Right now Vegetron's total market value (price per share times the number of shares outstanding) is \$10 million. That includes \$1 million cash we can invest in project X. The value of Vegetron's other assets and opportunities must therefore be \$9 million. We have to decide whether it is better to keep the \$1 million cash and reject project X or to spend the cash and accept project X. Let us call the value of the new project PV. Then the choice is as follows:

 Asset Market Value (\$ millions) Reject Project X Accept Project X Cash 1 0 Other assets 9 9 Project X 0 PV 10 9 + PV

Brealey-Meyers: I I. Value I 5. Why Net Prsnt Value I I © The McGraw-Hill

Principles of Corporate Leads to Better Companies, 2003 Finance, Seventh Edition Investments Decisions than Other Criteria

92 PART I Value

### FIGURE 5.1

The firm can either keep and reinvest cash or return it to investors. (Arrows represent possible cash flows or transfers.) If cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.

Investment opportunity (real asset)