UT FIN 357 - Chapter 4. Discounted Cash Flow Valuation v4 (70 pages)

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Discounted Cash Flow Valuation Chapter 4 Finance 357 J David Miller 2017 Future Value Most projects in the real world involve decisions about the future Project Cost 100 000 today Benefit 105 000 in one year Would you suggest that your company accept the project 2 J David Miller 2017 Finding Present Value Project Cost 100 000 today Benefit 105 000 in one year Suppose the interest rate was 7 We can move the benefit back to today by discounting it to find the present value PV 105 000 1 7 98 130 84 The net benefit today would be 100 000 98 130 84 1 869 16 We call the net benefit today the net present value NPV 3 J David Miller 2017 Net Present Value The net present value or NPV is the present value of cash flows we receive minus the present value of cash we must pay out The book uses the formula NPV Cost PV Using the previous example we were told that the cost was 100 000 today and we found that the present value that we would receive was 98 130 84 NPV 100 000 98 130 84 1 869 16 4 J David Miller 2017 Net Present Value Decision Rule The NPV Decision Rule says that we accept projects if they have a positive NPV If we must decide between multiple projects we accept the project with the greatest NPV This is a fundamental rule of finance 5 J David Miller 2017 Net Present Value Problem A year ago you developed an app that you believe will revolutionize the dry cleaning industry You are already so busy managing the business that you barely have time for school The app is currently being used by 350 dry cleaning businesses A larger mobile app company has offered to buy the business for 1 000 000 once it is being used by 500 businesses At the rate it is growing that will be at the end of two years However if you hired a professional manager who would cost 100 000 in salary you believe that it would reach that level at the end of one year Should you continue to manage the business yourself or hire the manager 6 J David Miller 2017 Net Present Value Problem A year ago you