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should be discounted, We know the answer in principle: discount cash Haws. ... Linear programming can solve this problem and help the financial manager.
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PRINCIPLES OF CORPORATE FINANCE RICHARD BREALEY . London Bu:,'ini!ss School

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MAKING INVESTMENT' DECISIONS WITH THE NET PRESENT VALUE RULE

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\YJe hope that by now you are convinced that wise investment decisions are based on the net present value rule. In this chapter we can think about how to apply the ruk to practical investment problems, Our task is threefold. The ti.rst issue is to decide what should be discounted, We know the answer in principle: discount cash Haws. But useiul forecas'ts of cash Hows do not arrive on a silver planer, Often the ti.nancial manager has to make do with raw data supplied by specialists in product design, production. marketing, taxation and so on, and must check such iniormation for relevance. completeness, consistency, and accuracy and then pull everything together into a usable forecast, Our second task is to explain how the net present value rule should be used when there are project interactions. These occur when a decision about one project cannot be separated from a decision about another. Project interactions can be extremely complex. We will make no attempt to analyze every possible case. But we will work through most of the simple cases, as well as a few examples of medium complexity, Our third task is to develop procedures for coping with capital rationing or other situations in which resources are strictly limited, There are (\VO aspects to this problem, One is computationaL Resource constraints often create problems of such complexity that a hunt-and-peck search for the right answer cannot cope with the vast number of alternatives, Linear programming can solve this problem and help the financial manager handle some project interactions at the same time, The other parr of the problem is deciding whether capital rationing really exists and whether it invalidates net present value as a criterion for capital budgeting. Our discussion of these issues will take tis back to the first principles outlined in Chapter 2.

6-1 WHAT TO DISCOUNT Up to this point we have been concerned mainly with the mechanics of discounting and with the various methods of project appraisal. We have had almost norhing to say about the problem of 11'/lL1t one should discount. \Vhen you ate faced with this problem. you should always stick to three general rules: [, Only cash t10w is relevant. 2, Always estimate cash tlows on an incremental 3, Be consistenc

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We will discuss each of these rules in turn.

Only Cash Flow is R~levant The ti.rst and most imporrant point is that the net presenc value rule is stated in terms of cash tlaws. Cash tlow is the simplest possible concept; it is just the difference between

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