Lecture 5 - Investment Rules and Net Present Value (NPV)

Introduction

• Discussion on present values and the time value of money.
• Focus on investment rules in finance.
• Key question: How to make smart investments?

Financial Viability of Projects

• Financial managers need to evaluate if a project is viable financially.
• Evaluation done using Net Present Value (NPV) and other investment rules.

Net Present Value (NPV)

• Definition: NPV = Initial cash outflow + Present value of future cash flows.
• Formula:
  • NPV = (-C_0 + \frac{C_1}{1+R} + \frac{C_2}{(1+R)^2} + \dots + \frac{C_M}{(1+R)^M})
  • Initial cash flow is not discounted.
• R (Discount Rate):
  • Market alternative rate of return.
  • Represents the risk and yield rate of similar market alternatives.
  • Higher risk requires a higher discount rate.

Evaluating NPV

• NPV > 0: Indicates economic profit. Beats market alternative.
• NPV < 0: Financially not viable. Underperforms against market benchmark.
• Positive NPV: Benefits shareholders by exceeding what they could achieve independently.

Steps in Estimating NPV

1. Identify initial investment ((C_0)).
2. Estimate future cash flows (size and timing).
3. Determine appropriate discount rate ((R)).

NPV as Golden Standard

• Preferred rule for identifying good investments.
• Benefits shareholders, uses all cash flows, discounts them properly.
• The value of the firm rises by NPV of the project.

Spreadsheet Calculation of NPV

• Use Excel's NPV function.
• Correct calculation by multiplying Excel's NPV result by (1+R) due to period assumption.

Other Investment Rules

Payback Period

• Definition: Time it takes to recoup the initial investment.
• Disadvantages:
  • Ignores time value of money.
  • Ignores cash flows after payback period.
  • Requires arbitrary acceptance criteria.
• Should not be the sole decision-making tool.

Discounted Payback Period

• Improvement: Considers time value of money.
• Drawbacks: Ignores all cash flows after the payback period.
• Loses simplicity compared to regular payback period.

Summary

• NPV should always be the main decision rule.
• Payback period and discounted payback period can supplement NPV evaluation.
• Correct calculation techniques are crucial for accurate evaluation.