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Principles of Corporate Finance

Seventh Edition

Chapter 6
Making Investment Decisions with the Net Present Value Rule

Richard A. Brealey Stewart C. Myers

Slides by Matthew Will


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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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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
Points to Watch Out For 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

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Inflation
INFLATION RULE 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

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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+ nominal interest rate 1 real interest rate = 1+inflation rate

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Inflation
Example - nominal figures

Year Cash Flow 1 2 3 4 8000 8000x1.03 = 8240 8000x1.03 = 8240 8000x1.03 = 8487.20
3 2

PV @ 10%
8000 1.10

7272.73 6809.92 6376.56 5970.78

8240 1.102 8487 .20 1.103 8741.82 1.104

$26,429.99
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Inflation
Example - real figures

Year 1 2 3 4
8000 1.03 8240 1.032 8487.20 1.033 8741.82 1.034

Cash Flow = 7766.99 = 7766.99 = 7766.99 = 7766.99


7766.99 1.068 7766.99 1.0682 7766.99 1.0683 7766.99 1.0684

PV@6.7961% 7272.73 6809.92 6376.56 5970.78 = $26,429.99

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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.

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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.

present value of costs Equivalent annual cost = annuity factor

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Equivalent Annual Cost


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 0 15 10

Machine A B

1 5 6

2 5 6

3 5

PV@6% 28.37 21.00

EAC 10.61 11.45

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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.
Net future value as of date t Current NPV t (1 r )

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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?
Harvest Year 0 1 2 3 4 5 Net FV ($1000s) 50 64.4 77.5 89.4 100 109.4 % change in value 28.8 20.3 15.4 11.9 9.4

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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?

64.4 NPV if harvested in year 1 58.5 1.10

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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?

64.4 NPV if harvested in year 1 58.5 1.10


Harvest Year 0 1 2 3 4 5 NPV ($1000s) 50 58.5 64.0 67.2 68.3 67.9
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