Making Investment Decisions

with the NPV Rule

 Topics Covered
 Applying the Net Present Value Rule
 Example-IM&C Project

 Using the NPV Rule to Choose Among

Projects
 Applying Net Present Value Rule
 Rule 1: Only Cash Flow is Relevant
 Capital Expenses
 Record capital expenditures when they occur
 To determine cash flow from income, add back

depreciation and subtract capital expenditure

 Working Capital
 Difference between company’s short-term assets
and liabilities
 Applying Net Present Value Rule
 Rule 2: Estimate Cash Flows on an
Incremental Basis
 Include taxes, salvage value, incidental
effects, and opportunity costs
 Do not confuse average with incremental
payoffs
 Forecast sales today, recognize after-sales
cash flow to come later
 Forget sunk costs

 Beware of allocated overhead costs

 Applying Net Present Value Rule
 Rule 3: Treat Inflation Consistently
 Use nominal interest rates to discount
nominal cash flows
 Use real interest rates to discount real cash

flows
 Same results from real and nominal figures
Example:
Project produces real cash flows of -$100 in
year zero and then $35, $50, and $30 in three
following years. Nominal discount rate is 15%
and inflation rate is 10%. What is NPV?

Real discount rate = 1+ nominal discountrate

1+inflation rate 1
1.15
  1  .045
1.10
Example (nominal figures): Cont.

Year Cash Flow PV @ 15%

0  100  100
1 35 1.10 = 38.5 138 .5
.15
 33.48
2 50 1.102 = 60.5 160.5
.152
 45.75
3 30 1.103 = 39.9 139.9
.153
 26.23
 $5.5
Example (real figures): Cont.

Year Cash Flow PV@4.50%

0  100  100
1 35 35
1.045
= 33.49
50
2 50 1.0452
= 45.79
30
3 30 1.0453
= 26.29
= $5.50
 Applying Net Present Value Rule
 Rule 4: Separate Investment and
Financing Decisions
 Regardless of financing, treat cash outflows
required for project as coming from
investors
 Regardless of financing, treat cash inflows

as going to investors
Example: IM&C’s Fertilizer Project
The International Mulch and Compost (IM&C) firm
analyses a proposal for a garden fertilizer. The project
requires an investment of $10 million in plant and
machinery (line 1). This machinery can be dismantled
and sold for net proceeds estimated at $1.949 million in
year 7 (line 1, column 7). This amount is your forecast
of the plant’s salvage value. Whoever prepared the
Table depreciated the capital investment over six years
to an arbitrary salvage value of $500,000, which is less
than your forecast of salvage value. Straight line
depreciation was assumed. Under this method annual
depreciation equals a constant proportion of the initial
investment less salvage value ($9.5 million).
 IM&C’S Garden Fertilizer Project
(reflecting inflation and assuming straight-line depreciation, $000s)

aSalvage value.
bWe have departed from the usual income-statement format by not including depreciation in cost

of goods sold. Instead, we break out depreciation separately (see line 9).
cStart-up costs in year 0 and 1, and general and administrative costs in years 1 to 6.
dThe difference between the salvage value and the ending book value of $500 is a taxable profit.

Depreciation = 1/T x depreciable amount = 1/6 x 9.5 = 1.583 million.

Initial investment less arbitrary salvage value = 10 - 0.5 = 9.5 million.
 IM&C’S Garden Fertilizer Project,
Net Cash Flow Analysis ($000s)

aSalvage value of $1,949 less tax of $507 on the difference between salvage value and ending
book value.
Net cash flow = cash flow from capital investment and disposal + cash flow from changes in
working capital + operating cash flow.
 IM&C’S Garden Fertilizer Project
NPV Using Nominal Cash Flows
1,630 2,381 6,205 10,685 10,136
NPV  12,600   2
 3
 4

1.20 (1.20) (1.20) (1.20) (1.20) 5
6,110 3,444
 6
 7
 3,520, or.$3,520,000
(1.20) (1.20)
 IM&C’S Garden Fertilizer Project
(details of cash flow forecast in year 3, $000s)

This provides an analysis of cash inflows and cash outflows for year three. This should
be worked out for each year.
Working Capital = Inventory + Accounts Receivable – Accounts Payable
Additional Investment in Working Capital = increase in inventory + increase in accounts receivable
– increase in accounts payable = 972 + 1500 - 500 = 1,972
This table is provided by Internal Revenue Service. Generally, there are two ways to depreciate an
asset: the straight-line method and MACRS. The current rules for tax depreciation in the US were set
by the Tax Reform Act of 1986, which established a Modified Accelerated Cost Recovery System
(MACRS). Tax depreciation is lower in the first and last years because assets are assumed to be in
service for only six months.
IM&C’S Garden Fertilizer Project,
Tax Payments ($000s)
IM&C’S Garden Fertilizer Project,
Revised Cash Flow Analysis ($000s)
 Using the NPV Rule to Choose
among Projects
 Problem 1: Investment Timing Decision
 Some projects are more valuable if
undertaken in the future
 Examine start dates (t) for investment and

calculate net future value for each date

 Discount net values back to present
 Using the NPV Rule to Choose
among Projects
 Problem 2: Choice between Long- and

Short-Term Equipment
Example:
Given the following cash flows from operating two machines
(identical capacity and produce exactly the same product, we are
comparing only costs) and a 6% cost of capital, which machine
has the higher value using the equivalent annual annuity method?

Costs ($000s)
Year: 0 1 2 3 PV@6% E.A.A.
Machine A +15 +5 +5 +5 28.37 10.61
Machine B +10 +6 +6 21.00 11.45
 Example: Cont.
 Should we take machine B, the one with the lower present
value of costs?
 Not necessarily, All we have show is that machine B offers

two years of service for a lower total cost than three years of
service from machine A.
 But is the annual cost of using B lower than that of A?

 We calculated the equivalent annual cost by finding the 3-

year annuity with the same PV as A’s lifetime costs.
PV of annuity = PV of A’s costs = 28.37 = Annuity Payment x
3-year annuity factor
Annuity Payment (A) = PV of A’s costs/3-year annuity factor =
28.37/2.673 = 10.61
Annuity Payment (B) = 21/1.8333 = 11.45
 Using the NPV Rule to Choose
among Projects
 Equivalent Annual Cash Flow, Inflation, and
Technological Change
 Inflation increases nominal costs of operating
equipment, but real costs remain unchanged
 Real cash flows are not always constant
 Equivalent Annual Cash Flow and Taxes
 Lifetime costs should be calculated after tax
 Operating costs are tax-deductible
 Capital investment generates depreciation tax
shields
 Using the NPV Rule to Choose
among Projects
 Problem 3: When to Replace an Old
Machine
 Problem 4: Cost of Excess Capacity
Web Resources
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
 Lecture 5: Practice Homework

 BMA2017: Chapter 6
 All Examples
 Exercises: 5, 7, 8, 15, 16, 21, 27, 29, 31