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NPV is an abbreviation for Net Present Value. NPV is the sum of the current and discounted future cash flows of an investment.
A future cash flow is worth less than a current cash flow, due to the time value of money. If the annual interest rate is denoted as "r", then our cash at the bank, denoted as "C", will grow to C x (1 + r)^1 at the end of year 1. Using the same principle on an inverse basis, the future cash at the bank in one year, denoted as "FC", will be FC / (1 + r)^1 today. This is because if we put FC / (1 + r)^1 in the account today, we will have FC x (1 + r)^1 / (1 + r)^1 = FC in one year. This sums up the notion of discounted cash flows, it is adjusted for the time value of money.
Thus investing 80 USD today for a known income of 100 in one year, with r=10%, yields an NPV of -80 + 100/1.10 ~= 10.9. I.e., the investment today of 80 is not discounted since it is done today (no time effect) and the cash flow in one year is discounted by the interest rate for one year.
The letter "r" in this case, is your discount rate. The discount rate is often the same as the cost of capital. The cost of capital is what investors expect in return for their investments. When using bank debt, is simply the interest rate paid. When using equity financing, the cost of capital depends on the amount of risk in the investment, i.e. what the equity investors expect given the level of risk they are taking. Thus if the investment is perceived as risky, the cost of capital will rise, and when the cost of capital rises, the future cash flow is discounted to a larger degree (since C / (1+r) goes down if "r" goes up).
The rule is to make an investment if it has a positive NPV value. The investment above has a positive NPV given a 10% discount rate, but not given a 30% discount rate.
Thus, in summary: NPV is a way of calculating the profit of a project taking the time effect of money, given the risk of the project, into the calculation. The cost of capital is what is expected in return from your investors given their investment and the risk involved.
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What is the effect on IRR if cost of capital decreased?
A change in the cost of capital will not, typically, impact on the IRR. IRR is measure of the annualised effective interest rate, or discount rate, required for the net present values of a stream of cash flows to equal zero. The IRR will not be affected by the cost of capital; instead you should compare the IRR to the cost of capital when making investment decisions. If the IRR is higher than the cost of capital the project/investment should be viable (i.e. should have a positive net present value - NPV). If the IRR is lower than the cost of capital it should not be undertaken. So, whilst a higher cost of capital will not change the IRR it will lead to fewer investment decisions being acceptable when using IRR as the method of assessing those investment decisions.
Does lower WACC equal lower NPV?
no it increases npv
What if your firm is considering a project that will cost 4.55 million upfront generate cash flows of 5 million per year for three years and then have a cleanup and shutdown cost of 6 million in the f?
Your firm is considering a project that will cost $4.55 million upfront, generate cash flows of $5 million per year for three years, and then have a cleanup and shutdown cost of $6 million in the fourth year. Assume a discount rate of 10% per annum, what is the NPV of this project? a. None of the other answers are true. b. The NPV of this project is $3.44 million. c. The NPV of this project is $3.34 million. d. The NPV of this project is $10.89 million.
What do you understand by cost of capital?
cost of capital
What do you mean by horizon value in finding the NPV of a stock?
horizon value = FCF(1+g)/WACC - g where FCF = Free cash flows at current time period or sub zero g= growth rate of firm WACC=weighted average cost of capital ----
What happens to NPV when cost of capital increased?
NPV decreases when the cost of capital is increased.
The NPV assumes cash flows are reinvested at the?
The NPV assumes cash flows are reinvested at the: A. real rate of return B. IRR C. cost of capital D. NPV
Why the NPV of a relatively long term project is more sensitive to changes in the cost of capital than is the NPV of a short term project?
due to the uncertainty
What happens to NPV if the cost of capital changes?
The cost of capital is inversely proportional to the NPV. As capital costs increase (i.e. the interest rate increases), NPV decreases. As capital costs decrease (i.e. the interest rate decreases), NPV increases. You can see the relationship in the following equation: NPV = a * ((1+r)^y - 1)/(r * (1+r)^y) Where: NPV = Net Present Value (The present value of a future amount, before interest earnings/charges) a = Amount received per year y = Number of years r = Present rate of return
If the opportunity cost of capital for a project exceeds the projects IRR then the project has a NPV negative?
If the opportunity cost of capital for a project exceeds the Project's IRR, then the project has a(n)
Calculate rate of return?
NPV/Initial Cost of Investment
How do you make capital budgeting?
by considering npv analysis , irr and pay back period
How are projects selected under capital rationing?
on the basis of projects having higher npv
What are the Similarities between NPV and IRR?
They explain the time value of money 􀂃 Both useful in capital budgeting and investment valuation
What is the effect on IRR if cost of capital decreased?
A change in the cost of capital will not, typically, impact on the IRR. IRR is measure of the annualised effective interest rate, or discount rate, required for the net present values of a stream of cash flows to equal zero. The IRR will not be affected by the cost of capital; instead you should compare the IRR to the cost of capital when making investment decisions. If the IRR is higher than the cost of capital the project/investment should be viable (i.e. should have a positive net present value - NPV). If the IRR is lower than the cost of capital it should not be undertaken. So, whilst a higher cost of capital will not change the IRR it will lead to fewer investment decisions being acceptable when using IRR as the method of assessing those investment decisions.
Equipment A has a cost of Rs75000 and net cash flow of Rs20000 per year for six years A substitute equipment B would cost Rs50000 and generate net cash flow of Rs14000 per year for six years?
Equipment A NPV = 75000 - 120000 = 45000 Equipment B NPV = 50000 - 84000 = 34000 Based on NPV Equipment A should be selected
Which capital budgeting technique is consistent with maximizing shareholder wealth and why?
NPV analysis is what they teach in MBA programs and what CFOs everywhere use.
