Firms Investment Decision and Net present Value Criterion

The Firm’s Investment Decision:

Net present Value Criterion:

• If the PV of the expected ca:sh flow generated by an investment is greater than the PV of the cost of the investment, then a firm should make the investment.

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• If NPV > 0, the firm undertakes the investment. If NPV < 0, the firm does not.

Firm’s Discount Rate:

• The discount rate on a particular project is the rate of return on the firm’s next best alternative investment project with the same risk. In other words, the discount rate is the opportunity cost of capital invested in projects with the same risk. It is necessary for the firm to put projects in different risk categories, because investors insist on earning higher rates of return on riskier For “safe” or low-risk investments, a common measure of the opportunity cost of capital is the rate of return on a 10-year U.S. Treasury Bond. Because there is essentially no risk of the U.S. government defaulting on its bonds, the return on a government bond is considered a risk-free return. Firms and individuals forever have the opportunity to invest in risk-free U.S. government bonds.

Example: suppose that prior to August 1, 2008, Disney is considering building a Phantasmic theme restaurant at its MGM Studios them park at Disney World in Orlando, FL. The restaurant will cost $6million to build and Disney expects it to generate a cash flow of $1 million per year for each of the next 10 years. After 10 years, Disney plans to completely change the theme of the restaurant and expects to sell the salvageable equipment for $1.2 million. Based on the estimates, Disney needs to determine whether it should build the new restaurant. Now, using different discount rates of 5%, 10%, and 15%, calculate the respective NPVs. And if the Disney’s expected cash flow from the restaurant decreases by 25% due to unexpected financial turmoil, how do the NPVs change?

Internal Rate of Return Criterion:

• An alternative to the net present value criterion for evaluating investments is the internal rate of return (IRR) of an investment, which is the discount rate for which the net present value of the investment equals zero. He IRR criterion for an investment states that if the IRR is greater than the firm’s required rate of return on investments, the firm should undertake the investments; if the IRR is less than the firm’s required rate of return, the firm should not undertake the investment. What is the firm’s necessary rate of return? If the firm is borrowing to pay for the investments, the required rate of return will be the cost of borrowing. The firm then undertakes the investment if and only if the IRR is greater than the firm’s cost of borrowing.

• For any investment there forever exists at least one IRR. Consider the Disney example (page 90). The IRR is computed by setting the NPV equal to zero as follows:

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Solving by trial and error, IRR = 0.121:

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If Disney’s cost of borrowing is less than 12.1 percent, Disney will build the restaurant.

Real versus Nominal Discount Rates and Cash Flows:

• Real values adjust for inflation; nominal values do not. The real interest rate on a bond measures the increase in real purchasing power that the purchaser receives each year. The difference between the real and nominal interest rate can be closely approximated by:
r ≅ i − π (8)

• For example, if a government bond pays a nominal 7% each year and the inflation rate is 2%, then the real interest rate is approximately 5%. The use of the nominal interest rate overstates the increase in purchasing power to the lender each year. Suppose an individual purchases a $10,000 one-year bond paying a nominal 7% interest rate. The bond holder receives a $700 interest payment plus a $10,000 principal repayment next year. In nominal terms, the bond holder sacrificed $10,000 of purchasing power this year in return for $10,700 of purchasing power next year. In real terms nevertheless if the price index is 1.00 today and inflation is 2%, then the price index next year is 1.02. In return for sacrificing $10,000 in purchasing power today, the lender receives $10,700/$1.02 = $10,490.20 in purchasing power next year, or slightly under a 5% real return.

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