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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

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
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
What To Discount

Only Cash Flow is Relevant

what to discount1
What To Discount

Only Cash Flow is Relevant

what to discount2
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
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

inflation1
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?

inflation2
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?

inflation3
Inflation

Example - nominal figures

inflation4
Inflation

Example - real figures

im c s guano project
IM&C’s Guano Project

Revised projections ($1000s) reflecting inflation

im c s guano project1
IM&C’s Guano Project
  • NPV using nominal cash flows
im c s guano project2
IM&C’s Guano Project

Cash flow analysis ($1000s)

im c s guano project3
IM&C’s Guano Project

Details of cash flow forecast in year 3 ($1000s)

im c s guano project4
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 project5
IM&C’s Guano Project

Tax Payments ($1000s)

im c s guano project6
IM&C’s Guano Project

Revised cash flow analysis ($1000s)

timing
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.
timing1
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?

timing2
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?

timing3
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

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

equivalent annual cost1
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 cost2
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 cost3
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

Machine1 2 3 4 [email protected]% EAC

A 15 5 5 5 28.37

B 10 6 6 21.00

equivalent annual cost4
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

Machine1 2 3 4 [email protected]% EAC

A 15 5 5 5 28.37 10.61

B 10 6 6 21.00 11.45

machinery replacement
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
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

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