Principles of Corporate Finance Seventh Edition Richard A. Brealey Chapter 6 Making Investment Decisions with the Net Present Value Rule Stewart C. Myers Slides by Matthew Will McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 2 Topics Covered What To Discount IM&C Project Project Interaction Equivalent Annual Cost Î Replacement Î Timing Î Fluctuating Load Factors Î McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 3 What To Discount Only Cash Flow is Relevant McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 4 What To Discount Points to “Watch Out For” ÂDo not confuse average with incremental payoffs ÂInclude all incidental effects ÂDo not forget working capital requirements ÂForget sunk costs ÂInclude opportunity costs ÂBeware of allocated overhead costs McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 5 Inflation INFLATION RULE 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 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 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? 1+ nominal interest rate 1 + real interest rate = 1+inflation rate McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 7 Inflation Example - nominal figures Year 1 2 3 4 Cash Flow PV @ 10% 8000 8000 1.10 = 7272.73 8240 8000x1.03 = 8240 = 6809.92 1.102 2 8487 .20 8000x1.03 = 8240 = 6376.56 1.103 .82 8000x1.033 = 8487.20 8741 = 5970.78 1.104 $26,429.99 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 8 Inflation Example - real figures Year 1 2 3 4 McGraw Hill/Irwin 8000 1.03 8240 1.032 8487.20 1.033 8741.82 1.034 Cash Flow = 7766.99 = 7766.99 = 7766.99 = 7766.99 7766.99 1.068 7766.99 1.0682 7766.99 1.0683 7766.99 1.0684 PV@6.7961% = 7272.73 = 6809.92 = 6376.56 = 5970.78 = $26,429.99 Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 9 Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine. present value of costs Equivalent annual cost = annuity factor McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 10 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. Machine A B McGraw Hill/Irwin Year 0 15 10 1 5 6 2 5 6 3 5 PV@6% 28.37 21.00 EAC 10.61 11.45 Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 11 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. Net future value as of date t Current NPV = t (1 + r ) McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 12 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? Net FV ($1000s) % change in value McGraw Hill/Irwin Harvest Year 0 1 2 3 50 64.4 77.5 89.4 28.8 20.3 4 5 100 109.4 15.4 11.9 9.4 Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 13 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? 64.4 NPV if harvested in year 1 = = 58.5 1.10 0 1 NPV ($1000s) 50 58.5 McGraw Hill/Irwin Harvest Year 2 3 64.0 67.2 4 5 68.3 67.9 Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 6- 14 Aufgaben zu Hause Q7 PQ10, 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved