CHAPTER 15 • Investment, Time, and Capital Markets 569 The solution to this equation is R* = 11.099 percent Why was the yield on the Rite Aid bond so much higher than on the Microsoft bond? Because the Rite Aid bond was much riskier By 2011, the drug store chain was suffering large losses due to increasing competition from larger chains like Wal-Mart, which were able to use their scale to undercut prices on everything from toiletries to prescription drugs Between 2007 and 2011, Rite Aid turned a profit for only one quarter, leading many analysts to predict bankruptcy Consistent with this, Rite Aid’s bond was rated CCC (the lowest ranking) Because investors knew that there was a significant possibility that Rite Aid would default on its bond payments, they were prepared to buy the bond only if the expected return was high enough to compensate them for the risk 15.4 The Net Present Value Criterion for Capital Investment Decisions One of the most common and important decisions that firms make is to invest in new capital Millions of dollars may be invested in a factory or machines that will last—and affect profits—for many years The future cash flows that the investment will generate are often uncertain And once the factory has been built, the firm usually cannot disassemble and resell it to recoup its investment—it becomes a sunk cost How should a firm decide whether a particular capital investment is worthwhile? It should calculate the present value of the future cash flows that it expects to receive from the investment and compare it with the cost of the investment This method is known as the net present value (NPV) criterion: NPV criterion: Invest if the present value of the expected future cash flows from an investment is larger than the cost of the investment In §7.1, we explain that a sunk cost is an expenditure that has been made and cannot be recovered • net present value (NPV) criterion Rule holding that one should invest if the present value of the expected future cash flow from an investment is larger than the cost of the investment Suppose a capital investment costs C and is expected to generate profits over the next 10 years of amounts p1, p2,…, p10 We then write the net present value as NPV = -C + p10 p1 p2 + + g + (1 + R) (1 + R) (1 + R)10 (15.3) where R is the discount rate that we use to discount the future stream of profits (R might be a market interest rate or some other rate; we will discuss how to choose it shortly.) Equation (15.3) describes the net benefit to the firm from the investment The firm should make the investment only if that net benefit is positive—i.e., only if NPV > DETERMINING THE DISCOUNT RATE What discount rate should the firm use? The answer depends on the alternative ways that the firm could use its money For example, instead of this investment, the firm might invest • discount rate Rate used to determine the value today of a dollar received in the future