1. Making Investment Decisions With the Net Present Value Rule
Principles of
Corporate Finance
Tenth Edition
Chapter 6
Making Investment Decisions With the Net Present Value Rule
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

2. Topics Covered Applying the Net Present Value Rule IM&C Project
Investment Timing
Equivalent Annual Cash Flows 2 2 2 2 3 2

3. Only Cash Flow is Relevant
What To Discount
Rule 1
Only Cash Flow is Relevant

4. What To Discount Points to “Watch Out For”
Rule 2: Estimate Cash Flows on an Incremental Basis
Do not confuse average with incremental payoffs
Include all incidental effects
Forecast Sales Today and Recognize After-Sales Cash Flows to come Later
Do not forget working capital requirements
Include opportunity costs
Forget sunk costs
Beware of allocated overhead costs
Remember salvage value

5. Inflation Rule 3 - Treat Inflation Consistently
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 12

6. Inflation
Example
You invest in a project that will produce real cash flows of -$100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project? 14

7. Inflation
Example
You invest in a project that will produce real cash flows of -$100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project? 14

8. Inflation
Example - nominal figures 15

9. Inflation
Example - real figures 16

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

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

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

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

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

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

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

17. Investment Timing
Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow. 38

18. Investment Timing Example
You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities. The longer you wait, the higher the investment required. On the other hand, lumber prices will rise as you wait, and the trees will keep growing, although at a gradually decreasing rate. Given the following data and a 10% discount rate, when should you harvest? 39

19. Investment Timing Answer: Year 4 Example
You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities. The longer you wait, the higher the investment required. On the other hand, lumber prices will rise as you wait, and the trees will keep growing, although at a gradually decreasing rate. Given the following data and a 10% discount rate, when should you harvest?
Answer: Year 4 39

20. Investment Timing Another Example
You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? 39

21. Investment Timing
Another Example
You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer?
Year Cost PV Savings NPV at Purchase NPV Today
Date to purchase 25.5 40

22. Equivalent Annual Cash Flows
Equivalent Annual Cash Flow - The cash flow per period with the same present value as the actual cash flow as the project. 42

23. Equivalent Annual Cash Flows
Example
Given the following cash flows from operating two machines and a 6% cost of capital, which machine has the higher value using equivalent annual annuity method.
Year
Mach E.A.A. A B
10.61
11.45
28.37
21.00 45

24. Equivalent Annual Cash Flows
Another Example
Select one of the two following projects, based on highest “equivalent annual cash flow” (r=9%).
2.82
2.78
.87
1.10 47