Slides by Matthew Will

1. 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

2. Topics Covered • What To Discount • IM&C Project • Project Interaction • Timing • Equivalent Annual Cost • Replacement • Cost of Excess Capacity • Fluctuating Load Factors

3. What To Discount Only Cash Flow is Relevant

4. What To Discount Only Cash Flow is Relevant

5. 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”

6. 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

7. 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?

8. 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?

9. Inflation Example - nominal figures

10. Inflation Example - real figures

11. IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

12. IM&C’s Guano Project • NPV using nominal cash flows

13. IM&C’s Guano Project Cash flow analysis ($1000s)

14. IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

15. IM&C’s Guano Project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) - (Figures in percent of depreciable investment).

16. IM&C’s Guano Project Tax Payments ($1000s)

17. IM&C’s Guano Project Revised cash flow analysis ($1000s)

18. 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.

19. 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?

20. 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?

21. 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?

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

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

24. 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.

25. 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 PV@6% EAC A 15 5 5 5 28.37 B 10 6 6 21.00

26. 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 PV@6% EAC A 15 5 5 5 28.37 10.61 B 10 6 6 21.00 11.45

27. 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.

28. 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

29. Fluctuating Load Factors

30. Fluctuating Load Factors

31. Fluctuating Load Factors