Lecture V: Finish Single Investments and Start Multiple Investment

I. Complicated NPV Formulation

A. As some have indicated in class, the investment decision is much more
complex than the simple examples covered thus farm. In general, one
must consider taxes, inflation, and general economic trends.
B. A more complete formulation of the NPV model would be
t
 1+ g 
NPV = ∑ NCFATt  
 (1 + r (1 − T ) ) (1 + z ) 
1. NCFATt is the net cash flow after tax in period t. Typically, the
tax code drives a wedge between the gross revenue received and
profit retained in the firm.
a. In the past marginal tax rates have been as high as 80
percent. Now the highest marginal tax rate is 33 percent.
b. Other factors have also distorted the tax effect. For
example, investment tax credit in the pre 1986 tax code
allowed up to 10 percent of the asset price to be used to
directly reduce taxes payable, and the capital gains
exclusion reduced to 40 percent the marginal tax rate on
capital gains.
c. In the current code the only remaining distortion apart from
the marginal tax rate, is the allowance for depreciation. For
simplicity
NCFATt = NCFt (1 − T ) + T Dept
where Dept is the depreciation allowance under the current
tax codes.
2. The well-known Fisher equation is used to relate the nominal
interest rate to the pure cost of capital in society.
(1 + r )(1 + z ) = 1 + r + z + rz
because both r and z are rates rz approaches zero. Thus,
(1 + r )(1 + z ) B 1 + r + z
In Fisher’s case, this meant that
R =r +z
where R is the nominal interest rate, r is the purchasing power
constant interest rate, and z is the inflation rate. For real
applications note that we cannot observe r and z is difficult to
project with the best macroeconomic models, but we can observe
R. Hence, for our applications
t
 1+ g 
NPV = ∑ NCFATt  
1 + R (1 − T ) 
Notice
(1 − T ) R = (1 − T ) r + (1 − T ) z
AEB 6145 –Lecture V
Professor Charles B. Moss
If we don’t believe in Fisher’s approximation
(1 − T ) R = (1 − T ) r + (1− T ) z + (1− T ) rz
(1 + (1 − T ) R ) = 1 + (1 − T ) r + (1 − T ) z + (1 − T ) rz
= 1 + (1 − T ) r + z + (1 − T ) rz − Tz
By synthetic division
1+ z
1 + (1 − T ) r 1 + (1 − T ) r + z + (1 − T ) rz − Tz
1 + (1 − T ) r
z + (1 − T ) rz − Tz
z + (1 − T ) rz
− Tz
Therefore,
1 + (1 − T ) R = (1 + (1 − T ) r ) (1 + z ) − Tz
3. g is the growth rate or constant trend in income. This figure is
convenient for several simplifications:
a. Assume: An asset with a life of 10 years with a rate of
return of $100 in period 1 growing at a rate of 3%. The
initial cost is $3,000 and the salvage value is $4,000. What
is the present value of the investment assuming a 28 % tax
rate and a nominal interest rate of 12 %?

Annual return $100 (1-.28)=$72. In the present U.S. tax

code, the purchase price of an investment (such as a bond
or stock) is not tax deductible. Hence, the NCFAT series
for the investment becomes:
Table 1. After Tax Cash Flows
Year Cash Flow (After Tax)
0 -3,000
1 72
2 72(1+.03)
3 72(1+.03)2
M
10 72(1+.03)9 +4,000-.28(4,000-3,000)
The annual cash flows then become
Table 2. After Tax Annual Cash Flows
Year Annual Cash Flows (After Tax)
1 72/(1.03) (1.03)1
2 72/(1.03) (1.03)2
3 72/(1.03) (1.03)3
M
10 72/(1.03) (1.03)10
The present value of this series then becomes

2
AEB 6145 –Lecture V
Professor Charles B. Moss
1 2 10
72  1.03  72  1.03  72  1.03 
  +   +L  
1.03  1+ .12 (1 − .28)  1.03  1+ .12 (1 − .28)  1.03  1+ .12 (1 − .28 ) 
Note
 1.03  1
 =
1 + .12 (1 − .28 )  1.05476
72
= 69.9029
1.03
Present value of operating flows:
  1  
10

  − 
1.05476  
1
69.9029   = 69.9029 ( 7.5463) = 527.5089
 .05476 
 
 
Present value of investment
4,000 − .28 (1,000 )  3424.1532 
PV = −3,000 + 527.5089 + 10 
= 
(1 + .12 (1 − .28) )  1.0547610 
= 951.6621
II. Multiple Investments
A. In multiple investment scenarios we are typically dealing with some fault
in the perfect market assumptions. Either capital is constrained, the
projects are not independent, or some other factor is inconsistent.
B. Simple first step–optimal replacement. A critical question for many
economic situations is when to replace a piece of equipment. Under
certainty assumptions and given that the equipment is replaced by an
identical piece of equipment, the replacement occurs when the annualized
present cost of the machine is minimized. Here we are comparing
alternative investments among holding the tractor for different periods.