Making Investment Decisions with the Net Present Value Rule Chapter 6
Topics Covered What To Discount IM&C Project Project Interaction Equivalent Annual Cost Replacement Project Interaction Timing Fluctuating Load Factors
What To Discount Only Cash Flow is Relevant
What To Discount Do not confuse average with incremental payoffs 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”
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
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?
Inflation Example - nominal figures
Inflation Example - real figures
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)
Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.
Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.
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
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.
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?
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?
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?
Fluctuating Load Factors