Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 9. Net Present Value and

Other Investment Criteria

(^306) © The McGraw−Hill
Companies, 2002
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. Cal-
culating 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 [1
(1/1.15^8 )]/.15 (2,000/1.15^8 )
($6,000 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:
NPV
$30,000 27,578 
$2,422
Therefore, this is nota good investment. Based on our estimates, taking it would de-
creasethe total value of the stock by $2,422. With 1,000 shares outstanding, our best es-
timate 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 ef-
fect would be favorable. As a consequence, all we need to know about a particular pro-
posal 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 discus-
sion 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.
276 PART FOUR Capital Budgeting

FIGURE 9.1

0

–$30

–$30

12345678

$ 20

• 14
  $ 6

$ 6

Time

(years)

Initial cost

Inflows

Outflows

Net inflow

Salvage

Net cash flow

$ 20

• 14
  $ 6

$ 6

$ 20

• 14
  $ 6

$ 6

$ 20

• 14
  $ 6

$ 6

$ 20

• 14
  $ 6

$ 6

$ 20

• 14
  $ 6

$ 6

$ 20

• 14
  $ 6

$ 6

$ 20

• 14
  $ 6
  2
  $ 8

Project Cash Flows ($000)

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