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

© The McGraw−Hill^307

Companies, 2002

Two comments about our example are in order. First and foremost, it is not the rather
mechanical process of discounting the cash flows that is important. Once we have the
cash flows and the appropriate discount rate, the required calculations are fairly straight-
forward. The task of coming up with the cash flows and the discount rate in the first
place is much more challenging. We will have much more to say about this in the next
several chapters. For the remainder of this chapter, we take it as a given that we have es-
timates of the cash revenues and costs and, where needed, an appropriate discount rate.
The second thing to keep in mind about our example is that the
$2,422 NPV is an
estimate. Like any estimate, it can be high or low. The only way to find out the true NPV
would be to place the investment up for sale and see what we could get for it. We gen-
erally won’t be doing this, so it is important that our estimates be reliable. Once again,
we will have more to say about this later. For the rest of this chapter, we will assume the
estimates are accurate.

As we have seen in this section, estimating NPV is one way of assessing the prof-
itability of a proposed investment. It is certainly not the only way profitability is as-
sessed, and we now turn to some alternatives. As we will see, when compared to NPV,
each of the alternative ways of assessing profitability that we will examine is flawed in
some key way; so NPV is the preferred approach in principle, if not always in practice.

CHAPTER 9 Net Present Value and Other Investment Criteria 277

Using the NPV Rule

Suppose we are asked to decide whether or not a new consumer product should be launched.

Based on projected sales and costs, we expect that the cash flows over the five-year life of

the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last

year. It will cost about $10,000 to begin production. We use a 10 percent discount rate to eval-

uate new products. What should we do here?

Given the cash flows and discount rate, we can calculate the total value of the product by

discounting the cash flows back to the present:

Present value ($2,000/1.1) (2,000/1.1^2 ) 4,000/1.1^3 )

(4,000/1.1^4 ) (5,000/1.1^5 )

$1,818 1,653 3,005 2,732 3,105

$12,313

The present value of the expected cash flows is $12,313, but the cost of getting those cash

flows is only $10,000, so the NPV is $12,313 
10,000 $2,313. This is positive; so, based

on the net present value rule, we should take on the project.

EXAMPLE 9.1

SPREADSHEET STRATEGIES

Calculating NPVs with a Spreadsheet

Spreadsheets are commonly used to calculate NPVs. Examining the use of

spreadsheets in this context also allows us to issue an important warning.

Let’s rework Example 9.1: