NPV and Bond Valuation
The first eight chapters in this reader will study the time value of money, the
old and simple idea that says money now is more valuable than money later. This
notion, embodied in the net present value (NPV) concept, allows us to compare
projects with different time profiles. Chapter 2 reviews the main rules in project
evaluation. Chapter 3 introduces the Capital Asset Pricing Model (CAPM), and
assesses its importance for evaluating risky projects. Chapter 5 develops the concept
of a weighted cost of capital. Chapters 6 and 7 show how the above concepts are
used by practitioners. Chapters 4 and 8 are the questions that will help you in the
1.1. What is Net Present Value?
Suppose you are offered a second-hand printing machine that costs you $20,000.
this machine will allow you to make and sell labels, and every year you will make
a profit of $5,000, net of repairs and the costs of doing business. Is this a good
Suppose that I decide to draw $50,000 from my bank's credit line today (2007),
and that I will refinance this amount forever. The bank charges me a 10% interest
on my credit line balance. I use some of this money to buy the printing machine.
Let us look at the net payoffs from my borrowing
Table 1. Payoffs from borrowing and buying a printing machine
Year 2007 2008 2009 ... 2127
Borrow from bank $50,000 -$5000 -$5000 -$5000
Buy Machine -$20,000 $5000 $5000 $5000
Net Position $30,000 $0 $0 $0
As you can see, the bank should be very happy lending me the money, since I
definitely have the ability to pay them back. The fact that I pocket $30,000 today
you can think of as a measure of how profitable the investment is. I could buy a
BMW with my good idea. The $30,000 is also know as the net present value of this
The concept of net present value is old, and it says that:
(1 + r)t
â¢ CFt stands for the cash flows that you receive in period t. These cash...