One of the basic financial principles is that the value of any asset (whether it be a stock, a...


One of the basic financial principles is that the value of any asset (whether it be a stock, a bond, or a firm as a whole) is the present value of that asset's future cash flows. As you learned in your chapter, finding present values requires determining a discount rate. Assume you want to buy a business, and you want to find the present value of its future cash flows. Name at least one variable you should consider in determining the correct discount rate to use and explain its role in discount rate determination. Identify a variable based on this information.

Net Present Value of a Investment Decision:

Prior to making an investment decision, a finance manager should calculate the net present value, or NPV, of the investment. If the NPV is greater than zero and higher than other opportunities available, then the manager should accept the investment.

Answer and Explanation:

An investor should use the NPV calculation, using the expected return for other investment opportunities with a similar level of risk as the discount rate. We do it this way because of the opportunity cost of investing in this project. For example, if you wanted to purchase a coffee shop for $100,000, you will need to examine other ways the $100,000 could be invested and determine the expected return. If you found an alternative opportunity with a 10% return, then the 10% would be your discount rate. The formula for the NPV is

{eq}NPV = \sum_{t=1}^{T}\frac{C_{t}}{(1+r)^{t}}-C_{0} {/eq}

Learn more about this topic:

Cost of Capital: Flotation Cost, NPV & Internal Equity


Chapter 3 / Lesson 18

How does a business figure out the true cost and best means of obtaining capital? In this lesson, we will explore the cost of capital, flotation cost, net present value, and internal equity to help answer that question.

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