Making Investment Decisions with the Net Present Value Rule Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 6 McGraw Hill/Irwin

6- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  What To Discount  IM&C Project  Project Interaction  Equivalent Annual Cost  Replacement  Project Interaction  Timing  Fluctuating Load Factors

6- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved What To Discount Only Cash Flow is Relevant

6- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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”

6- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved  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 INFLATION RULE

6- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

6- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Inflation Example - nominal figures

6- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Inflation Example - real figures

6- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

6- 10 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project  NPV using nominal cash flows

6- 11 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project Cash flow analysis ($1000s)

6- 12 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

6- 13 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) (Figures in percent of depreciable investment)

6- 14 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project Tax Payments ($1000s)

6- 15 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved IM&C’s Guano Project Revised cash flow analysis ($1000s)

6- 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

6- 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

6- 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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 A B Equivalent Annual Cost

6- 19 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

6- 20 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

6- 21 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

6- 22 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

6- 23 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Fluctuating Load Factors

6- 24 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Fluctuating Load Factors

6- 25 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Fluctuating Load Factors

6- 26 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter7, P