1. Chapter 5 Principles PrinciplesofCorporateFinance Tenth Edition Net Present Value and Other Investment Criteria Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 2 McGraw Hill/Irwin Topics Covered  Applying the Net Present Value Rule  IM&C Project  Equivalent Annual Costs

3. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 3 McGraw Hill/Irwin What To Discount Only Cash Flow is Relevant

4. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 7 McGraw Hill/Irwin Inflation Example - nominal figures

8. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 8 McGraw Hill/Irwin Inflation Example - real figures

9. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 9 McGraw Hill/Irwin IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

10. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 10 McGraw Hill/Irwin IM&C’s Guano Project  NPV using nominal cash flows

11. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 11 McGraw Hill/Irwin IM&C’s Guano Project Cash flow analysis ($1000s)

12. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 12 McGraw Hill/Irwin IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

13. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 14 McGraw Hill/Irwin IM&C’s Guano Project Tax Payments ($1000s)

15. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 15 McGraw Hill/Irwin IM&C’s Guano Project Revised cash flow analysis ($1000s)

16. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 19 McGraw Hill/Irwin Equivalent Annuities Example (with a twist) Instead of calculating an equivalent annual cost, what if you were asked to calculate the equivalent annual annuity on a series of cash flows with a positive NPV. Which project would you select with the following cash flows and a 9% discount rate? Project01234NPVEq. Ann. C-154.95.25.96.22.82.87 D-208.18.710.42.781.10

20. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 20 McGraw Hill/Irwin Web Resources 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 Click to access web sites Internet connection required