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NPV RULE FOR CAPITAL BUDGETING
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Choose a project if it costs less than the PV of its cash flows. More generally:
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take a project if its Net Present Value is positive.
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EXAMPLE
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Interest rate10%
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Year0123
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Cash flow (600) 200 200 500
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PV factor100%91%83%75%
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PV of cash flow (600) 182 165 376
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Cumulative PV (600) (418) (253) 123
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Net Present Value 123
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Investors would have to invest 123 more (a total of 723) to get the cash flows of 200, 200,
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and 500 at an interest rate of 10%. Therefore the project has a value of 123 for investors.
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The interest rate is called the cost of capital, because it is the opportunity cost of funds - the
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rate investors can earn on alternative investments.
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