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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

- What To Discount
- IM&C Project
- Project Interaction
- Timing
- Equivalent Annual Cost
- Replacement
- Cost of Excess Capacity
- Fluctuating Load Factors

Only Cash Flow is Relevant

Only Cash Flow is Relevant

- 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”

- 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

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?

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?

Example - nominal figures

Example - real figures

Revised projections ($1000s) reflecting inflation

- NPV using nominal cash flows

Cash flow analysis ($1000s)

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

Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) - (Figures in percent of depreciable investment).

Tax Payments ($1000s)

Revised cash flow analysis ($1000s)

- 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.

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?

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?

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

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

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.

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

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

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.

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