Present Worth Analysis. Park 5. Loan Versus Project Cash Flows. An investment made in a fixed asset is similar to an investment made by a bank when it lends money.
Present Worth Analysis Park 5
Loan Versus Project Cash Flows • An investment made in a fixed asset is similar to an investment made by a bank when it lends money. • The essential characteristic of both transactions is that funds are committed today in the expectation of their earning a return in the future. • Loan cash flow: the future return is interest plus repayment of the principle. • Project cash flow: the future return is earnings along with capital expenditures and annual expenses.
Payback Screening • Determines how long it takes for a company to recover the investment in a project. • The expected cash flows for each year are added until the sum is equal to or greater than zero. Once greater than zero, the project generates profit. • This calculation can be done by either ignoring or considering time value of money (conventional-payback and discounted-payback method) • A project does not merit consideration unless its payback period is shorter than some specified period of time.
Present-Worth Analysis • Present-Worth analysis take into account the time value of money to help improve project evaluations. • Most convenient time to calculate equivalent values is at time zero (present). • NPW (net present worth) is the difference between the present worth of all cash inflows and the present worth of all cash outflows.
Present-Worth Criterion • Step 1: Determine the interest rate that the firm wishes to earn on its investment (MARR, minimum attractive rate of return) • Step 2: Estimate service life of project. • Step 3: Estimate cash inflow for each period over the service life. • Step 4: Estimate cash outflow for each period over the service life.
Present-Worth Criterion • Step 5: Determine the net cash flows for each period (Cash inflow-cash outflow) • Step 6: Find the present worth of each net cash flow at the MARR and add them to determine the project’s NPW. • Step 7: If: • PW(i) > 0, accept the investment • PW(i) = 0, remain indifferent • PW(i) < 0, reject the investment
Capitalized-Equivalent Method • The capitalized cost represents the amount of money that must be invested today in order to yield a certain return A at the end of each and every period, forever, assuming an interest rate of i. • PW(i) = A/i (A = iPW(i)) • If withdrawals were higher than A, you would be eating into the principle, which would eventually reduce it to zero.
Comparing Alternatives • Doing nothing: Is the alternative worth pursuing? • Service projects: Which alternative has the least input or cost? • Revenue projects: Which alternative has the largest net gains (output-input)?