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From a purely mechanical perspective, we need to calculate the present value of the future cash flows at 15 percent. The net cash inflow will be $20,000 cash income less $14,000 in costs per year for eight years. These cash flows are illustrated in Figure 9.1. As Figure 9.1 suggests, we effectively have an eight-year annuity of $20,000 - 14,000 = $6,000 per year, along with a single lump-sum inflow of $2,000 in eight years. Calculating the present value of the future cash flows thus comes down to the same type of problem we considered in Chapter 6. The total present value is:

Present value = $6,000 X [1 - (1/1.158)]/.15 + (2,000/1.158) = ($6,000 X 4.4873) + (2,000/3.0590) = $26,924 + 654 = $27,578

When we compare this to the $30,000 estimated cost, we see that the NPV is:

Therefore, this is not a good investment. Based on our estimates, taking it would decrease the total value of the stock by $2,422. With 1,000 shares outstanding, our best estimate of the impact of taking this project is a loss of value of $2,422/1,000 = $2.42 per share.

Our fertilizer example illustrates how NPV estimates can be used to determine whether or not an investment is desirable. From our example, notice that if the NPV is negative, the effect on share value will be unfavorable. If the NPV were positive, the effect would be favorable. As a consequence, all we need to know about a particular proposal for the purpose of making an accept-reject decision is whether the NPV is positive or negative.

Given that the goal of financial management is to increase share value, our discussion in this section leads us to the net present value rule:

An investment should be accepted if the net present value is positive and rejected if it is negative.

In the unlikely event that the net present value turned out to be exactly zero, we would be indifferent between taking the investment and not taking it.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria

© The McGraw-Hill Companies, 2002

CHAPTER 9 Net Present Value and Other Investment Criteria



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