Introduction to Finance

cost of capital
, is 10 
percent. In Chapter 18, we will cover the process of determining the cost of capital.
We apply the NPV technique to projects A and B. Their cash fl ows are shown in 
Table 17.2
. 
Assuming a 10 percent cost of capital, the cash fl ows are multiplied by the 10 percent 
present value interest factor (PVIF) (from Table 2 in the Appendix) to get the PVs shown in 
Table 17.3
. There is no discount factor for the initial outlays because they occur before any 
time has passed (i.e., in year zero). Positive NPVs are shown for both projects. This means 
an investment in either project will add to shareholder wealth. However, project A, with the 
higher NPV of $1,982, is preferable to project B, which has a NPV of $988.
A positive NPV means the project’s cash infl ows are suffi
cient to repay the initial, 
up-front (time zero) costs as well as the fi nancing cost of 10 percent over the project’s life. 
Since their NPVs are greater than zero, each project’s return is greater than the 10 percent 
cost of capital.
cost of capital 
project’s required 
rate of return
TA B L E 1 7 . 2
Cash Flow Data for Projects A and B
Year
Project A
Project B
0
$–20,000 $–25,000
1
5,800
4,000
2
5,800 
4,000
3
5,800 
8,000
4
5,800 
10,000
5
5,800
10,000
TA B L E 1 7 . 3
Net Present Value Calculations for Projects A and B
Project A
Project B
Year
Cash Flow
×
10% PVIF
=
Present Value
Cash Flow
×
10% PVIF
=
Present Value
0
–$20,000
1.000
–$20,000
–$25,000
1.000
–$25,000
1 
5,800
0.909
5,272
4,000
0.909
3,636
2 
5,800
0.826
4,791
4,000
0.826
3,304
3 
5,800
0.751
4,356
8,000
0.751
6,008
4 
5,800
0.683
3,961
10,000
0.683
6,830
5 
5,800
0.621
3,602
10,000
0.621
6,210
Net present value = $1,982
Net present value = $988

---

17.3 Capital Budgeting Techniques—Net Present Value