 Making Investment Decisions with the Net Present Value Rule Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 6 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 2 Topics Covered  What To Discount  IM&C Project  Project Interaction  Timing  Equivalent Annual Cost  Replacement  Cost of Excess Capacity  Fluctuating Load Factors

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 3 What To Discount Only Cash Flow is Relevant

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 4 What To Discount Only Cash Flow is Relevant

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 5 What To Discount  Do not confuse average with incremental payoff.  Include all incidental effects.  Do not forget working capital requirements.  Forget sunk costs.  Include opportunity costs.  Beware of allocated overhead costs. Points to “Watch Out For”

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 6  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. Inflation INFLATION RULE

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 7 Inflation Example You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 8 Inflation Example You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 6- 9 Inflation Example - nominal figures

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Inflation Example - real figures

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project  NPV using nominal cash flows

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project Cash flow analysis ($1000s)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) - (Figures in percent of depreciable investment).

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project Tax Payments ($1000s)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill IM&C’s Guano Project Revised cash flow analysis ($1000s)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Timing  Even projects with positive NPV may be more valuable if deferred.  The actual NPV is then the current value of some future value of the deferred project.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Timing Example You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Timing Example - continued You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Timing Example - continued You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Equivalent Annual Cost Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Equivalent Annual Cost Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method. Year A B

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method. Year A B Equivalent Annual Cost

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Machinery Replacement Annual operating cost of old machine = 8 Cost of new machine Year: % Equivalent annual cost of new machine = 27.4/(3-year annuity factor) = 27.4/2.5 = 11 MORAL: Do not replace until operating cost of old machine exceeds 11.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Cost of Excess Capacity A project uses existing warehouse and requires a new one to be built in Year 5 rather than Year 10. A warehouse costs 100 & lasts 20 years. Equivalent annual 10% = 100/8.5 = With project Without project Difference PV extra cost = = (1.1) 6 (1.1) 7 (1.1) 10

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Fluctuating Load Factors

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Fluctuating Load Factors

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Fluctuating Load Factors