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

2. Topics Covered What To Discount IM&C Project Project Interaction
Timing
Equivalent Annual Cost
Replacement
Cost of Excess Capacity
Fluctuating Load Factors

3. What To Discount
Only Cash Flow is Relevant

4. What To Discount
Only Cash Flow is Relevant

5. What To Discount Points to “Watch Out For”
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.

6. Inflation INFLATION RULE 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 RULE 12

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? 13

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? 14

9. Inflation
Example - nominal figures 15

10. Inflation
Example - real figures 16

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

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

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

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

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

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

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

18. 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.

19. 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?

20. 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?

21. 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?

22. Equivalent Annual Cost
Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine. 41

23. Equivalent Annual Cost
Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine. 42

24. 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. 43

25. 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
Machine EAC A B 44

26. 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
Machine EAC A B 45

27. 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. 43

28. 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 = 11.7
With project
Without project
Difference
PV extra cost = = 27.6
(1.1) (1.1) (1.1)10

29. Fluctuating Load Factors

30. Fluctuating Load Factors

31. Fluctuating Load Factors