Chapter 6

Principles of
Corporate Finance
Tenth Edition

Making Investment
Decisions With the
Net Present Value
Rule
Slides by
Matthew Will

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Topics Covered
Applying the Net Present Value Rule
IM&C Project
Investment Timing
Equivalent Annual Cash Flows

6-2

What To Discount
Rule 1
Only Cash Flow is Relevant

6-3

What To Discount

6-4

Points to Watch Out For

Rule 2: Estimate Cash Flows on an Incremental Basis
Do not confuse average with incremental payoffs
Include all incidental effects
Forecast Sales Today and Recognize After-Sales Cash Flows
to come Later
Do not forget working capital requirements
Include opportunity costs
Forget sunk costs
Beware of allocated overhead costs
Remember salvage value

Inflation

6-5

Rule 3 - Treat Inflation Consistently

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

6-6

Inflation
Example
You invest in a project that will produce real cash
flows of -$100 in year zero and then $35, $50, and
$30 in the three respective years. If the nominal
discount rate is 15% and the inflation rate is 10%,
what is the NPV of the project?
1+nominal discount rate
real discount rate =
1+inflation rate

6-7

Inflation
Example
You invest in a project that will produce real cash
flows of -$100 in year zero and then $35, $50, and
$30 in the three respective years. If the nominal
discount rate is 15% and the inflation rate is 10%,
what is the NPV of the project?
real discount rate =

1+ nominal discount rate

1+ inflation rate

1.15
=
1 = .045
1.10

6-8

Inflation
Example - nominal figures

Year Cash Flow

0
- 100
1
35 1.10 = 38.5
2
3

50 1.10 2 = 60.5
30 1.10 3 = 39.9

PV @ 15%
100
38.5
= 33.48
1.15
60.5
1.152
39.9
1.153

= 45.75
= 26.23
$5.5

6-9

Inflation
Example - real figures

Year Cash Flow

0
- 100
1

35

50

30

PV@4.50%
100
35
1.045
50
1.045 2
30
1.045 3

= -33.49
= 45.79
= 26.29
= $5.5

6-10

IM&Cs Guano Project

Revised projections ($1000s) reflecting inflation

Period
1
2
3
4
5
6
7
8
9
10
11
12

Capital Investment
Accumulated depreciation
Year-end book value
Working capital
Total book value (3+4)
Sales
Cost of goods sold
Other Costs
Depreciation
Pretax profit (6-7-8-9)
Tax at 35%
Profit after tax (10-11)

0
10,000
10,000
10,000

4,000
(4,000)
(1,400)
2,600

1
1,583
8,417
550
8,967
523
837
2,200
1,583
(4,097)
(1,434)
(2,663)

2
3,167
6,833
1,289
8,122
12,887
7,729
1,210
1,583
2,365
828
1,537

3
4,750
5,250
3,261
8,511
32,610
19,552
1,331
1,583
10,144
3,550
6,595

4
6,333
3,667
4,890
8,557
48,901
29,345
1,464
1,583
16,509
5,778
10,731

5
7,917
2,083
3,583
5,666
35,834
21,492
1,611
1,583
11,148
3,902
7,246

6
9,500
500
2,002
2,502
19,717
11,830
1,772
1,583
4,532
1,586
2,946

7
(1,949)
-

1,449
507
942

IM&Cs Guano Project

NPV using nominal cash flows

1,630 2,381 6,205 10,685 10,136

NPV = 12,000
+
+
+
+
2
3
4
1.20 (1.20 ) (1.20 ) (1.20 ) (1.20 )5
6,110
3,444
+
+
= 3,520 or $3,520,000
6
7
(1.20 ) (1.20 )

6-11

6-12

IM&Cs Guano Project

Cash flow analysis ($1000s)
Period
0
1
2
3
4
5
6
7
8
9

Sales
Cost of goods sold
Other costs
Tax on operations
Cash flow from operations (12-3-4)
Change in working capital
Capital investment and
Net cash flow (5+6+7)
Present value at 20%

4,000
(1,400)
(2,600)
(10,000)
(12,600)
(12,600)

Net Present value= +3520 (sum of 9)

1
523
837
2,200
(1,434)

2
12,887
7,729
1,210
828

3
32,610
19,552
1,331
3,550

4
48,901
29,345
1,464
5,778

5
35,834
21,492
1,611
3,902

6
19,717
11,830
1,772
1,586

(1,080)
(550)

3,120
(739)

8,177
(1,972)

12,314
(1,629)

8,829
1,307

4,529
1,581

(1,630)
(1,358)

2,381
1,654

6,205
3,591

10,685
5,153

10,136
4,074

6,110
2,046

2,002
1,442
3,444
961

IM&Cs Guano Project

Details of cash flow forecast in year 3 ($1000s)

6-13

IM&Cs Guano Project

Tax depreciation allowed under the modified accelerated cost recovery
system (MACRS) (Figures in percent of depreciable investment)
Year(s)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17-20
21

Tax Depreciation Schedules by Recovery-Period Class

3-Year
5-Year
7-Year
10-Year
15-Year
33.33
20
14.29
10
5
44.45
32
24.49
18
9.5
14.81
19.2
17.49
14.4
8.55
7.41
11.52
12.49
11.52
7.7
11.52
8.93
9.22
6.93
5.76
8.92
7.37
6.23
8.93
6.55
5.9
4.45
6.55
5.9
6.56
5.9
6.55
5.9
3.29
5.9
5.9
5.91
5.9
5.91
2.99

20-Year
3.75
7.22
6.68
6.18
5.71
5.28
4.89
4.52
4.46
4.46
4.46
4.46
4.46
4.46
4.46
4.46
4.46
2.23

6-14

6-15

IM&Cs Guano Project

Tax Payments ($1000s)

0
1
2
3
4
5
6

Sales
Cost of goods sold
Other Costs
Tax depreciation
Pretax profit (1-2-3-4)
Taxes at 35%

4,000
(4,000)
(1,400)

1
523
837
2,200
2,000
(4,514)
(1,580)

2
12,887
7,729
1,210
3,200
748
262

3
32,610
19,552
1,331
1,920
9,807
3,432

Period
4
48,901
29,345
1,464
1,152
16,940
5,929

5
35,834
21,492
1,611
576
11,579
4,053

6
19,717
11,830
1,772
5,539
1,939

1,949
682

IM&Cs Guano Project

Revised cash flow analysis ($1000s)

6-16

Investment Timing
Sometimes you have the ability to defer an
investment and select a time that is more
ideal at which to make the investment
decision. A common example involves a
tree farm. You may defer the harvesting of
trees. By doing so, you defer the receipt of
the cash flow, yet increase the cash flow.

6-17

Investment Timing
Example
You own a large tract of inaccessible timber. To
harvest it, you have to invest a substantial amount
in access roads and other facilities. The longer
you wait, the higher the investment required. On
the other hand, lumber prices will rise as you
wait, and the trees will keep growing, although at
a gradually decreasing rate. Given the following
data and a 10% discount rate, when should you
harvest?

6-18

Investment Timing
Example
You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in
access roads and other facilities. The longer you wait, the higher the investment required. On the
other hand, lumber prices will rise as you wait, and the trees will keep growing, although at a
gradually decreasing rate. Given the following data and a 10% discount rate, when should you
harvest?

Answer: Year 4

6-19

Investment Timing
Another Example
You may purchase a computer anytime within the
next five years. While the computer will save your
company money, the cost of computers continues
to decline. If your cost of capital is 10% and
given the data listed below, when should you
purchase the computer?

6-20

6-21

Investment Timing
Another Example
You may purchase a computer anytime within the next five years. While
the computer will save your company money, the cost of computers
continues to decline. If your cost of capital is 10% and given the data
listed below, when should you purchase the computer?
Year

Cost

PV Savings

NPV at Purchase

0
1
2
3
4
5

50
45
40
36
33
31

70
70
70
70
70
70

20
25
30
34
37
39

NPV Today

20.0
22.7
24.8
Date to purchase 25.5
25.3
24.2

Equivalent Annual Cash Flows

6-22

Equivalent Annual Cash Flow - The cash flow

per period with the same present value as
the actual cash flow as the project.
present value of cash flows
Equivalent annual annuity =
annuity factor

Equivalent Annual Cash Flows

6-23

Example
Given the following cash flows from operating two
machines and a 6% cost of capital, which machine
has the higher value using equivalent annual annuity
method.

Mach. 0
A
+15
B
+10

Year
1
2
+5
+5
+6
+6

3
+5

PV@6%
28.37
21.00

E.A.A.
10.61
11.45

Equivalent Annual Cash Flows

Another Example
Select one of the two following projects, based on
highest equivalent annual cash flow (r=9%).

Project

C0

C1

C2

15 4.9 5.2

20

C3

C4

NPV

5.9 6.2 2.82

2.78
8.1 8.7 10.4

EAA
.87
1.10

6-24

Web Resources
Click to access web sites
Internet connection required

http://finance.yahoo.com
www.bloomberg.com
http://hoovers.com
www.investor.reuters.com
www.cbs.marketwatch.com
http://money.cnn.com
http://moneycentral.msn.com
www.euroland.com
www.valueline.com

6-25