Making Investment Decisions with the Net Present Value Rule

1. Chapter 6 Making Investment Decisions with the Net Present Value Rule

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

3. What To Discount Only Cash Flow is Relevant

4. What To Discount • Do not confuse average with incremental payoffs • 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”

5. 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

6. 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?

7. Inflation Example - nominal figures

8. Inflation Example - real figures

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

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

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

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

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

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

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

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

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

18. 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

19. 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.

20. 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?

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. 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?

23. Fluctuating Load Factors

24. Fluctuating Load Factors

25. Fluctuating Load Factors