1. Chapter 6 Principles of Corporate Finance Eighth Edition Making Investment Decisions With the Net Present Value Rule Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 2 McGraw-Hill/Irwin Topics Covered  What To Discount  IM&C Project  Equivalent Annual Costs  Project Interaction –Optimal Timing –Fluctuating Load Factors

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 3 McGraw-Hill/Irwin What To Discount Only Cash Flow is Relevant

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 4 McGraw-Hill/Irwin What To Discount  Estimate Cash Flows on an Incremental Basis  Do not confuse average with incremental payoffs  Include all incidental effects  Do not forget working capital requirements  Include opportunity costs  Forget sunk costs  Beware of allocated overhead costs  Treat inflation consistently Points to “Watch Out For”

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 5 McGraw-Hill/Irwin  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

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 6 McGraw-Hill/Irwin 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?

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 7 McGraw-Hill/Irwin Inflation Example - nominal figures

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 8 McGraw-Hill/Irwin Inflation Example - real figures

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 9 McGraw-Hill/Irwin IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 10 McGraw-Hill/Irwin IM&C’s Guano Project Cash flow analysis ($1000s)

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 11 McGraw-Hill/Irwin IM&C’s Guano Project  NPV using nominal cash flows

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 12 McGraw-Hill/Irwin IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 13 McGraw-Hill/Irwin IM&C’s Guano Project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) (Figures in percent of depreciable investment)

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 14 McGraw-Hill/Irwin IM&C’s Guano Project Tax Payments ($1000s)

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 15 McGraw-Hill/Irwin IM&C’s Guano Project Revised cash flow analysis ($1000s)

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 16 McGraw-Hill/Irwin Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 17 McGraw-Hill/Irwin Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 18 McGraw-Hill/Irwin 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 Machine1234PV@6%EAC A1555528.3710.61 B106621.0011.45 Equivalent Annual Cost

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 19 McGraw-Hill/Irwin 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.

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 20 McGraw-Hill/Irwin 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?

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 21 McGraw-Hill/Irwin 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 22 McGraw-Hill/Irwin 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?

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 23 McGraw-Hill/Irwin Fluctuating Load Factors

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 24 McGraw-Hill/Irwin Fluctuating Load Factors

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 25 McGraw-Hill/Irwin Fluctuating Load Factors

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 6- 26 McGraw-Hill/Irwin Web Resources www.investopedia.com/calculator/NetPresentValue.aspx www.finalyst.com/ www.toolkit.cch.com/text/P06_6530.asp Click to access web sites Internet connection required