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
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

6-5

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
0
1
2
3

Cash Flow
PV @ 15%
- 100
100
35 1.10 = 38.5 138.15.5 33.48
50 1.10 2 = 60.5 160.15.52 45.75
30 1.10 3 = 39.9 139.15.93 26.23
$5.5

6-9

Inflation
Example - real figures

Year
0
1
2

Cash Flow
- 100
35
50

30

35
1.045
50
1.045 2
30
1.045 3

PV@4.50%
100
= -33.49
= 45.79
= 26.29
= $5.5

IM&Cs Guano Project

Revised projections ($1000s) reflecting inflation

6-10

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
5
1.20 1.20
1.20 1.20 1.20
6,110
3,444

3,520 or $3,520,000
6
7
1.20 1.20

6-11

IM&Cs Guano Project

Cash flow analysis ($1000s)

6-12

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)

6-14

IM&Cs Guano Project

Tax Payments ($1000s)

6-15

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

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

0
1
2
3
4
5

70
70
70
70
70
70

20
25
30
34
37
39

50
45
40
36
33
31

NPV at Purchase NPV Today

20.0
22.7
24.8
Date to purchase 25.5

25.3
24.2

6-21

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

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.
Year
Mach. 0
A +15+5
B +10+6

1
+5
+6

2
+5

PV@6%

28.37
21.00

E.A.A.

10.61
11.45

6-23

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

NPV

EAA

5.9 6.2 2.82

8.1 8.7 10.4
2.78

.87
1.10

15 4.9 5.2

20

C3

C4

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