DADSS

1. DADSS NPV: part 2

2. Administrative • Homework 1 due today (now) • Homework 2 due Wednesday. • Homework 3 due January 29 (posted tonight) • Bring laptops again next class. • Start Decision Analysis next week

3. Last Time • Basic introduction to Net Present Value and how to calculate it in Excel.

5. Graphical Comparison of NPV

6. Examples • Choosing a project • Valuing an investment • Evaluating the effectiveness of a decision or strategy over time • Basically: How can I value things? Given values, what do they mean?

7. Specific Problem Types • Corporate Finance • Plant A requires a $100 million investment, but will return $50 million/yr for 10 years • Plant B requires only $50 million now, but another $75 million in 5 years. It will return $45 million/yr for 10 years • Which plant should the firm invest in?

8. Specific Problem Types • Should I go to College? (too late!) • Decision #1: Skip college and start work • No college costs and you start earning immediately, but your salary is (probably) lower • Decision #2: Go to college • College is expensive; you miss out on 4 years of earning power • However, you will (probably) earn more once you graduate • What should you do? • What salary premium would you have to earn in order to justify going to college?

9. Specific Problem Types • Retirement Planning • I want to retire in 20 years with an income of $100,000/yr • I have no current savings, but a large income • How much should I save if I want to meet my goal? • What kind of return do I need to get? • How does return trade off against the savings amount required?

10. The Key Elements • Value over time • Choices or Alternatives • Uncertainty • We’ll ignore uncertainty for now

11. Example: Borrowing Money • To buy some equipment for your business, you need to borrow $100,000 • The bank offers you a choice of 4 different payment arrangements, each with different terms • How should you choose between them? • Do you care? Does the bank care?

12. Example: Borrowing Money • Option #1: Capitalized interest at 6%, balloon payment in 10 years • Option #2: Interest-only for 10 years at 8%, then balloon payment at end • Option #3: Principal amortized, level payments for 10 years at 10% • Option #4: Constant paydown of $10,000/year plus interest, for ten years at 12%

13. Valuing Loan Options • Option #1 is a single payment in 10 years: CF/(1+0.06)10 • Option #2 is just interest (r × Loan) for 10 years, then you return the loan • Option #3 requires calculation of a finite stream of equal payments (sound familiar?) • Option #4 makes constant payments, but interest is reduced as the balance is paid down

14. Some Preliminary Thoughts… • Option 1 has the lowest interest rate and gives you the longest time to pay • Option 4 has the highest interest rate and you have to start paying a large amount immediately • #1 sounds much better than #4, right? • Always ask: What is the money worth right NOW?

15. Valuing Loan Options • Some observations: • Option #1 suffers from compounding – in the banks favor • Option #2 requires you to pay interest, but never reduce the principal • Option #3 means you have to start paying more now, but that means less interest later • Option #4 is like Option #2 with principal, or like Option #3 with the fixed amount set to $10,000 • What do the numbers say? • The purpose of modeling is insight! • We have carefully defined the problem, putting the different options into quantitative terms

16. Loan Options • The borrower (you) wants to pay as little in interest as possible • The bank wants you to pay as much in interest as possible • In light of these facts, what might we expect to be the case for each of the options given to the firm? • Why might this expectation be wrong?

17. Calculating Present Values

18. Conclusion? • The bank would be more than happy to have you accept Option #2 • Ever had your credit card company offer for you to “skip a payment”? • You should pick Option #3 (in the absence of any other considerations) • Why might some firms or managers prefer a different option? • Cash flow constraints • Revenue/Liability matching • Taxes

19. Back for More? Grad School… • One option available to you after you graduate is continuing on for a graduate degree • Is it worth it? • More informatively, under what circumstances would it be worthwhile?

20. Step 1: Make Some Assumptions • What to assume? • You’ll retire at the same age, whether or not you get an advanced degree • Post-graduate school compensation can be represented as a linear multiple of pre-graduate school pay • What alternative assumptions could we make? • Would such other assumptions have a big impact?

21. Step 1 Continued

22. Step 2: Putting the Model Together

23. Step 3: Analysis

24. Step 3: Analysis Measuring the Benefit (in present dollars) from Grad School

25. More and More Analysis • This is just the beginning • Creating a model of the decision problem allows us to explore an enormous variety of assumptions • One goal for good decisions? • Robustness

26. What’s Left Out? • Uncertainty • How do you trade off a certain value today for an uncertain value in the future? • Utility • Utility is a way of incorporating different attitudes toward risk (for or against) • Measures for Comparing Cash Flows • So far we’ve just valued cash flows. • NPV, IRR, MIRR, EUAC, Payback, etc.