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8/2/2019 Chapter_06 Making Investment Decisions With the Net Present Value Rule
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Making Investment Decisions
with the Net Present Value
Rule
Principles of
Corporate
Finance
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Slides by
Matthew Will
Chapter 6
McGraw Hill/Irwin Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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McGraw Hill/Irwin Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Topics Covered
What To Discount
Inflation
Equivalent Annual Cost
Project Interaction
Timing
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What To Discount
Only Cash Flow is Relevant
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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
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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
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Inflation
Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year for three years there after.
The forecasted inflation rate for the 4 years is 3 %per annum. If discount rates are 10% what is the
present value cost of the lease?
1 real interest rate =1+nominal interest rate
1+inflation rate
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McGraw Hill/Irwin Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Inflation
Example - nominal figures
Year Cash Flow PV @ 10%
1 80002 8000x1.03 = 8240
8000x1.03 = 8240
8000x1.03 = 8487.20
8000
1.10
2
3
7272 736809 92
3 637656
4 5970 78
429 99
8240
1 10
8487 20
1 10
8741 821 10
2
3
4
..
.
.
$26, .
.
.
.
..
8/2/2019 Chapter_06 Making Investment Decisions With the Net Present Value Rule
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McGraw Hill/Irwin Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Inflation
Example - real figures
Year Cash Flow [email protected]%
1 = 7766.992 = 7766.99
= 7766.99
= 7766.99
8000
1.03
7766.99
1.068
8240
1.03
8487.20
1.03
8741.821.03
2
3
4
7272 736809 92
3 6376 56
4 5970 78
26 429 99
7766 99
1 068
7766 99
1 068
7766 991 068
2
3
4
.
.
.
.
.
.
.
.
..
= $ , .
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Equivalent Annual Cost
Equivalent Annual Cost - The cost per periodwith the same present value as the cost of
buying and operating a machine.
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Equivalent Annual Cost
Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.
Equivalent annual cost =present value of costs
annuity factor
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McGraw Hill/Irwin Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
ExampleGiven the following costs of operating two machines
and a 6% cost of capital, select the lower cost machine
using equivalent annual cost method.
Year
Machine 0 1 2 3 PV@6% EAC
A 15 5 5 5 28.37 10.61B 10 6 6 21.00 11.45
Equivalent Annual Cost
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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.
tr
t
)1(dateofasvaluefutureNetNPVCurrent
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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?
9.411.915.420.328.8valueinchange%
109.410089.477.564.450($1000s)Net FV
543210
YearHarvest
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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?
5.581.10
64.41yearinharvestedif NPV
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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?
5.581.10
64.41yearinharvestedif NPV
67.968.367.264.058.550($1000s)NPV
543210
YearHarvest