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Here, we get positive NPV because PV of future cash inflow is higher than investment,
means your investment is able to maximize the value of your resources by tk. 3198. So it
will be wise for you to purchase the flat by which you will be able to maximize the value of
your resources.
So, according to finance, the objective of a firm is to maximize the value of firms resources.
Above example tells us that:
VALUE (tk. 18198.08) means PV of future cash inflows of any project
VALUE maximization level (tk. 3198.08) means excess value of investment
Now lets look at the above example further that you need tk.21, 500 to buy the flat, in that
case, NPV = -3302, which indicates that your value tk. 18198.08 is lower than your
investment by 3302 means value of resources is minimized rather than maximizing.
SHOULD YOU BUY THE FLAT in this case? Definitely NOT. Because, you want to maximize
the value of your resources rather than minimize.
How many important points we have learned from the above example?
(a) To calculate value of future cash flow i.e. VALUE of any investment
(b) Two important inputs are required to calculate VALUE i.e., cash flow stream and
discount rate
(c) Value maximization measures i.e., NPV (Positive NPV means value is maximized,
Negative NPV means value is minimized)
(d) First function of finance i.e. INVESTMENT DECISION (where should the firm invest?)
based on NPV, if select project with positive NPV, reject project with Negative NPV
as firms objective is maximizing the value of firm.
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Now lets look at, if your investment produces multiple cash flows based on the
sample example:
0
-15000
4000
5000
5500
5500 28000+5500=33500
4000/(1+.09)^1 5000/(1+.09)^2 5500/(1+.09)^3 5500/(1+.09)^4 33500/(1+0.09)^5
37794.17
37794.17-15000=22794.17
However, we can calculate the PV of annuity CF stream with alternative way by using PV
table as well. In this case
PV=ACF x PVIFA 9%, 5years
Here our Annuity CF (ACF) is tk. 7000 (equal CF in every period), PV Interest Factor
Annuity (PVIFA) for 9% and 5 years is 3.890 (this value is available from Financial table
which is attached in your email as well)
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CF
stream
-15000
2500
2500
2500 .
..
Here, equal CF for each year but for infinitive time. This type of CF steam is called PERPETUAL cash
flow stream, PV of Perpetual CF stream = Perpetual CF/DR
PV
2500/.09 = 27777.78
NPV
12777.78
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Summary Note:
We have learned to calculate the PV of different CF streams which can be faced by the firm
for its different type of investment opportunity. I hope based on this discussion, you will
come up with your understanding how to calculate the value of a firm or its any project.
The key challenges are that:
(a) What every the context, draw your time line
(b) Plot the CF in the time line according to the incidents
(c) Find DR
(d) Come up with the value, and compare it with your investment
(e) You can easily understand whether you will be able to maximize the value or not
(f) Finally, you can take the investment decision by selecting the project which is able
to maximize the value
I will highly appreciate your any questions about the above discussion for further
clarification.
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