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Seventh Edition
Chapter 6
Making Investment Decisions with the Net Present Value Rule
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Topics Covered
What To Discount
Inflation Equivalent Annual Cost Project Interaction Timing
McGraw Hill/Irwin
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What To Discount
McGraw Hill/Irwin
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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
McGraw Hill/Irwin
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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
McGraw Hill/Irwin
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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
McGraw Hill/Irwin
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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
$26,429.99
McGraw Hill/Irwin
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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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
McGraw Hill/Irwin
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Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.
McGraw Hill/Irwin
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McGraw Hill/Irwin
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Machine A B
1 5 6
2 5 6
3 5
McGraw Hill/Irwin
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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 )
McGraw Hill/Irwin
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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
McGraw Hill/Irwin
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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?
McGraw Hill/Irwin
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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?