Chapter 5 Principles PrinciplesofCorporateFinance Tenth Edition Net Present Value and Other Investment Criteria Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 2 McGraw Hill/Irwin Topics Covered  Applying the Net Present Value Rule  IM&C Project  Equivalent Annual Costs

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 3 McGraw Hill/Irwin What To Discount Only Cash Flow is Relevant

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 4 McGraw Hill/Irwin What To Discount  Estimate Cash Flows on an Incremental Basis  Do not confuse average with incremental payoffs  Include all incidental effects  Do not forget working capital requirements  Include opportunity costs  Forget sunk costs  Beware of allocated overhead costs  Treat inflation consistently Points to “Watch Out For”

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 5 McGraw Hill/Irwin  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

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 6 McGraw Hill/Irwin 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?

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 7 McGraw Hill/Irwin Inflation Example - nominal figures

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 8 McGraw Hill/Irwin Inflation Example - real figures

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 7- 9 McGraw Hill/Irwin IM&C’s Guano Project Revised projections ($1000s) reflecting inflation

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin IM&C’s Guano Project  NPV using nominal cash flows

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin IM&C’s Guano Project Cash flow analysis ($1000s)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin IM&C’s Guano Project Details of cash flow forecast in year 3 ($1000s)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin IM&C’s Guano Project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) (Figures in percent of depreciable investment)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin IM&C’s Guano Project Tax Payments ($1000s)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin IM&C’s Guano Project Revised cash flow analysis ($1000s)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Equivalent Annuities Example (with a twist) Instead of calculating an equivalent annual cost, what if you were asked to calculate the equivalent annual annuity on a series of cash flows with a positive NPV. Which project would you select with the following cash flows and a 9% discount rate? Project01234NPVEq. Ann. C D

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