Principles of cororate finance 6th brealey myers chapter 06

Principles of Corporate Finance
Brealey and Myers



Sixth Edition

Making Investment Decisions with
the Net Present Value Rule

Slides by
Matthew Will
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Chapter 6

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6- 2

Topics Covered
 What To Discount
 IM&C Project
 Project Interaction
Timing
 Equivalent Annual Cost
 Replacement
 Cost of Excess Capacity
 Fluctuating Load Factors


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6- 3

What To Discount
Only Cash Flow is Relevant

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6- 4

What To Discount
Only Cash Flow is Relevant

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6- 5

What To Discount
Points to “Watch Out For”

Do not confuse average with incremental
payoff.
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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6- 6

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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6- 7

Inflation
Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year (the forecasted inflation
rate) for 3 additional years (4 years total). If
discount rates are 10% what is the present value
cost of the lease?

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6- 8

Inflation
Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year (the forecasted inflation
rate) for 3 additional years (4 years total). 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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6- 9

Inflation
Example - nominal figures

Year Cash Flow

PV @ 10%

1

8000

8000
1.10

2

8000x1.03 = 8240

3

8000x1.032 = 8240

8240
1.102

8487 .20
1.103
8741.82
1.104

4

3

8000x1.03 = 8487.20

= 7272.73
= 6809.92
= 6376.56
= 5970.78

$26,429.99
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6- 10

Inflation
Example - real figures

Year
1
2

3
4

Cash Flow
8000
1.03
8240
1.032
8487.20
1.033
8741.82
1.034

= 7766.99
= 7766.99
= 7766.99
= 7766.99

%
7766.99
1.068
7766.99
1.0682
7766.99
1.0683
7766.99
1.0684

= 7272.73
= 6809.92

= 6376.56
= 5970.78
= $26,429.99

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6- 11

IM&C’s Guano Project
Revised projections ($1000s) reflecting inflation

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6- 12

IM&C’s 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
+
+
= 3,519 or $3,519,000
6
7
(1.20) (1.20)

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6- 13

IM&C’s Guano Project
Cash flow analysis ($1000s)

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6- 14

IM&C’s Guano Project
Details of cash flow forecast in year 3 ($1000s)

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6- 15

IM&C’s Guano Project
Tax depreciation allowed under the modified accelerated cost
recovery system (MACRS) - (Figures in percent of
depreciable investment).

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6- 16

IM&C’s Guano Project
Tax Payments ($1000s)

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6- 17

IM&C’s Guano Project
Revised cash flow analysis ($1000s)

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6- 18

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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6- 19

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?

0

1

Harvest Year
2
3

4

Net FV ($1000s)

50 64.4

77.5

89.4

% change in value

28.8

20.3

15.4 11.9

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5

100 109.4
9.4

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6- 20

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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6- 21

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
0

1

NPV ($1000s) 50 58.5
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Harvest Year
2
3
64.0

67.2

4

5

68.3 67.9

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6- 22

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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6- 23

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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6- 24

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.

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6- 25

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.

Machine
A
B

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Year
1
15
10

2
5
6

3
5
6

4
5

PV@6%
28.37
21.00

EAC

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