Making Investment Decisions With the Net Present Value Rule Principles of Corporate Finance Tenth Edition Chapter 6 Making Investment Decisions With the Net Present Value Rule Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

Topics Covered Applying the Net Present Value Rule IM&C Project Investment Timing Equivalent Annual Cash Flows 2 2 2 2 3 2

Only Cash Flow is Relevant What To Discount Rule 1 Only Cash Flow is Relevant

What To Discount Points to “Watch Out For” Rule 2: Estimate Cash Flows on an Incremental Basis Do not confuse average with incremental payoffs Include all incidental effects Forecast Sales Today and Recognize After-Sales Cash Flows to come Later Do not forget working capital requirements Include opportunity costs Forget sunk costs Beware of allocated overhead costs Remember salvage value

Inflation Rule 3 - Treat Inflation Consistently Be consistent in how you handle inflation!! Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. You will get the same results, whether you use nominal or real figures 12

Inflation Example You invest in a project that will produce real cash flows of -$100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project? 14

Inflation Example You invest in a project that will produce real cash flows of -$100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project? 14

Inflation Example - nominal figures 15

Inflation Example - real figures 16

IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

IM&C’s Guano Project NPV using nominal cash flows

IM&C’s Guano Project Cash flow analysis ($1000s)

IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

IM&C’s Guano Project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) (Figures in percent of depreciable investment)

IM&C’s Guano Project Tax Payments ($1000s)

IM&C’s Guano Project Revised cash flow analysis ($1000s)

Investment Timing Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow. 38

Investment Timing Example You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities. The longer you wait, the higher the investment required. On the other hand, lumber prices will rise as you wait, and the trees will keep growing, although at a gradually decreasing rate. Given the following data and a 10% discount rate, when should you harvest? 39

Investment Timing Answer: Year 4 Example You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities. The longer you wait, the higher the investment required. On the other hand, lumber prices will rise as you wait, and the trees will keep growing, although at a gradually decreasing rate. Given the following data and a 10% discount rate, when should you harvest? Answer: Year 4 39

Investment Timing Another Example You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? 39

Investment Timing Another Example You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? Year Cost PV Savings NPV at Purchase NPV Today 0 50 70 20 20.0 1 45 70 25 22.7 2 40 70 30 24.8 3 36 70 34 Date to purchase 25.5 4 33 70 37 25.3 5 31 70 39 24.2 40

Equivalent Annual Cash Flows Equivalent Annual Cash Flow - The cash flow per period with the same present value as the actual cash flow as the project. 42

Equivalent Annual Cash Flows Example Given the following cash flows from operating two machines and a 6% cost of capital, which machine has the higher value using equivalent annual annuity method. Year Mach. 0 1 2 3 PV@6% E.A.A. A +15 +5 +5 +5 B +10 +6 +6 10.61 11.45 28.37 21.00 45

Equivalent Annual Cash Flows Another Example Select one of the two following projects, based on highest “equivalent annual cash flow” (r=9%). 2.82 2.78 .87 1.10 47

Web Resources Click to access web sites Internet connection required http://finance.yahoo.com www.bloomberg.com http://hoovers.com www.investor.reuters.com www.cbs.marketwatch.com http://money.cnn.com http://moneycentral.msn.com www.euroland.com www.valueline.com