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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. Topics Covered. What To Discount IM&C Project

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Slides by Matthew Will

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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


Topics Covered

  • What To Discount

  • IM&C Project

  • Project Interaction

    • Timing

    • Equivalent Annual Cost

    • Replacement

    • Cost of Excess Capacity

    • Fluctuating Load Factors


What To Discount

Only Cash Flow is Relevant


What To Discount

Only Cash Flow is Relevant


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”


Inflation

  • 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


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

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)


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?


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.


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.


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

Machine1234PV@6%EAC

A1555528.37

B106621.00


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

Machine1234PV@6%EAC

A1555528.3710.61

B106621.0011.45


Machinery Replacement

Annual operating cost of old machine = 8

Cost of new machine

Year: 0123NPV @ 10%

15 5 5 5 27.4

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.


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 cost @ 10% = 100/8.5 = 11.7

0 . . . 56 . . . 1011 . . .

With project 0 0 11.7 11.7 11.7

Without project 00 0 0 11.7

Difference 0 0 11.7 11.7 0

PV extra cost = + + . . . + = 27.6

11.711.711.7

(1.1)6 (1.1)7 (1.1)10


Fluctuating Load Factors


Fluctuating Load Factors


Fluctuating Load Factors


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