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Earlier in the course, we talked about the main objective of a manager being

maximizing shareholder wealth.

How does a manager go about achieving this?

This requires a manager to select projects that add to shareholder wealth.

But usually there are a large number of projects to choose from.

Further, the manager does not have unlimited access to capital.

So there are constraints on how much capital she has for investments.

Given the potentially large number of projects to choose from and

the limited amount of capital available at the manager's disposal,

how do you decide which project to invest in?

This is the area of capital budgeting.

Starting with this video, we will look at a number of decision

tools that managers may use to identify profitable investment opportunities.

The first of which is the net present value, NPV in short.

We will see how to calculate the NPV and how to interpret the NPV

is forms the basis for accepting or rejecting a project.

Let's start off by seeing how to calculate the NPV of a project.

As the name suggests, we have to calculate the present value of a series of cash

flows including some negative once to determine the NPV of a project.

Let's start with a simple example to illustrate how to calculate NPV.

Let's say that a project requires an initial investment of $1 million today.

This investment will in turn generate cash flows of $200,000 a year for

the next nine years, which is the end of the project's useful life.

Assume that the cash flows are realized at the end of each year.

The appropriate discount rate for this project is 15%.

To calculate the NPV of this project we need to discount all cash flows back to

today using the discount rate of 15% and then add them all up,

including today's investment of a million dollars.

The NPV of this project is hence minus 1 million plus 200,000

divided by 1 plus 0.15 raised to the power of 1 plus 200,000

divided by 1 plus 0.15 raise to the power of 2 plus so

on until 200,000 divided by 1 plus 0.15 raise to the power of 9.

Ignoring the initial investment of a million dollars,

the annual cash flows of $200,000 from a nine payment ordinary annuity.

We can use the formula we saw earlier to calculate the present value of this

ordinary annuity.

Alternatively, we can use the PV function in Excel to calculate the present value of

the ordinary annuity.

The first import is the discount rate, which is enter as a decimal number, 0.15.

The second input is the number of payments which is nine for this ordinary annuity.

The third input is the amount of each payment which is $200,000.

The final two inputs to the PV formula are not element here and so

we can ignore that.

The PV function returns a value of $954,316.78,

which is the present value of annual in flows of $200,000 for the next nine years.

To get the NPV of this project we need to subtract the initial investment

of $1 million from the present value of 954,316.78.

You do not have to discount the initial investment as it is already measured in

present value, subtracting the $1 million from 954,316.78.

Gives us an NPV of -45,683.22.

So, what is this number mean?

Note, we will always denote cash inflows with the positive sign and

cash outflows with the negative sign.

In this example since the NPV is negative

it is telling us that the present value of outflows

are greater than the present value of inflows generated from the project.

That is, we do not recover our initial investment of $1 million from the project,

hence, our decision would be to reject the project.

NPV specifically tells us how much additional shareholder wealth is created,

are described by the project.

Here the negative NPV tells us that if the company would accept the project,

shareholder wealth would reduce by 45,683.22.

This is inconsistent with the manager's objective of maximizing shareholder

wealth, and hence the project is rejected.

A general formula for

NPV is the present value of inflows minus the present value of outflows.

Inflows are benefits, outflows are costs.

If the NPV is positive then benefits are greater than cost and

we will have a positive NPV.

This means that the project adds to shareholder wealth and

hence must be accepted.

On the other hand, having a negative NPV means cost outweigh the benefits and

the project reduces shareholder wealth and hence it must be rejected.

In summary, accept positive NPV projects and reject negative NPV project.

You are indifferent between accepting and rejecting a project if NPV

equals 0 as it neither increases nor decreases shareholder wealth.

Next time, we will look at the second type of investment decision rule.

Namely, the internal rate of return.

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