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trying to determine whether a proposed investment or project will be worth more, once it is in place, than it costs.

For reasons that will be obvious in a moment, the difference between an investment's market value and its cost is called the net present value of the investment, abbreviated NPV. In other words, net present value is a measure of how much value is created or added today by undertaking an investment. Given our goal of creating value for the stockholders, the capital budgeting process can be viewed as a search for investments with positive net present values.

With our run-down house, you can probably imagine how we would go about making the capital budgeting decision. We would first look at what comparable, fixed-up properties were selling for in the market. We would then get estimates of the cost of buying a particular property and bringing it to market. At this point, we would have an estimated total cost and an estimated market value. If the difference was positive, then this investment would be worth undertaking because it would have a positive estimated net present value. There is risk, of course, because there is no guarantee that our estimates will turn out to be correct.

As our example illustrates, investment decisions are greatly simplified when there is a market for assets similar to the investment we are considering. Capital budgeting becomes much more difficult when we cannot observe the market price for at least roughly comparable investments. The reason is that we are then faced with the problem of estimating the value of an investment using only indirect market information. Unfortunately, this is precisely the situation the financial manager usually encounters. We examine this issue next.

net present value (NPV)

The difference between an investment's market value and its cost.

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