10.

Chapter 10: Discounted cash flows

Exercise solutions for Management Science, ISBN 1-4039-4174-2
© H.G. Daellenbach and D.C. McNickle, 2005. Palgrave Publishers Ltd.

1. (a) Excel spreadsheet CH10EX1 reproduced below.

Yearly discounting
Year Option 1 Option 2 Discount Present Value i
i i factor Option 1 Option 2
0 S700000 S100000 1 S700,000.00 S100,000.00
1 30000 S20000 0.9091 27,272.73 S18,181.82
2 30000 S20000 0.8264 24,793.39 S16,528.93
3 30000 S20000 0.7513 22,539.44 S15,026.30
4 30000 S20000 0.6830 20,490.40 S13,660.27
5 30000 S20000 0.6209 18,627.64 S12,418.43
6 30000 S20000 0.5645 16,934.22 S11,289.48
7 30000 S20000 0.5132 15,394.74 S10,263.16
8 30000 S20000 0.4665 13,995.22 S9,330.15
9 30000 S20000 0.4241 12,722.93 S8,481.95
10 30000 S20000 0.3855 11,566.30 S7,710.87
11 30000 S20000 0.3505 10,514.82 S7,009.88
12 30000 S20000 0.3186 9,558.92 S6,372.62
13 30000 S20000 0.2897 8,689.93 S5,793.29
14 30000 S20000 0.2633 7,899.94 S5,266.63
15 30000 S20000 0.2394 7,181.76 S4,787.84
16 30000 S20000 0.2176 6,528.87 S4,352.58
17 30000 S20000 0.1978 5,935.34 S3,956.89
18 30000 S20000 0.1799 5,395.76 S3,597.18
19 30000 S20000 0.1635 4,905.24 S3,270.16
20 30000 S20000 0.1486 4,459.31 S2,972.87
NPV S444,593.09 S270,271.27

Net present value option 1 = Si444,593.09. Net present value option 2 = Si270,271.27.
Option 2 is preferred from a financial point of view.
(b)
Half yearly discounting
Periods Option 1 Option 2 Discount Present Value i
i i factor Option 1 Option 2
0 S700000 S100000 1 S700,000 S100,000
1 15000 S10000 0.9524 14,285.71 S9,523.81
2 15000 S10000 0.9070 13,605.44 S9,070.29
3 15000 S10000 0.8638 12,957.56 S8,638.38
4 15000 S10000 0.8227 12,340.54 S8,227.02
5 15000 S10000 0.7835 11,752.89 S7,835.26
6 15000 S10000 0.7462 11,193.23 S7,462.15
7 15000 S10000 0.7107 10,660.22 S7,106.81
8 15000 S10000 0.6768 10,152.59 S6,768.39
9 15000 S10000 0.6446 9,669.13 S6,446.09
10 15000 S10000 0.6139 9,208.70 S6,139.13
11 15000 S10000 0.5847 8,770.19 S5,846.79
12 15000 S10000 0.5568 8,352.56 S5,568.37
13 15000 S10000 0.5303 7,954.82 S5,303.21
14 15000 S10000 0.5051 7,576.02 S5,050.68
15 15000 S10000 0.4810 7,215.26 S4,810.17
16 15000 S10000 0.4581 6,871.67 S4,581.12
17 15000 S10000 0.4363 6,544.45 S4,362.97
18 15000 S10000 0.4155 6,232.81 S4,155.21
19 15000 S10000 0.3957 5,936.01 S3,957.34
20 15000 S10000 0.3769 5,653.34 S3,768.89
21 15000 S10000 0.3589 5,384.14 S3,589.42
22 15000 S10000 0.3418 5,127.75 S3,418.50
23 15000 S10000 0.3256 4,883.57 S3,255.71
24 15000 S10000 0.3101 4,651.02 S3,100.68
 10.2

25 15000 S10000 0.2953 4,429.54 S2,953.03

26 15000 S10000 0.2812 4,218.61 S2,812.41
27 15000 S10000 0.2678 4,017.72 S2,678.48
28 15000 S10000 0.2551 3,826.40 S2,550.94
29 15000 S10000 0.2429 3,644.19 S2,429.46
30 15000 S10000 0.2314 3,470.66 S2,313.77
31 15000 S10000 0.2204 3,305.39 S2,203.59
32 15000 S10000 0.2099 3,147.99 S2,098.66
33 15000 S10000 0.1999 2,998.09 S1,998.73
34 15080 S10000 0.1904 2,855.32 S1,903.55
35 15000 S10000 0.1813 2,719.35 S1,812.90
36 15000 S10000 0.1727 2,589.86 S1,726.57
37 15000 S10000 0.1644 2,466.53 S1,644.36
38 15000 S10000 0.1566 2,349.08 S1,566.05
39 15000 S10000 0.1491 2,237.22 S1,491.48
40 15000 S10000 0.1420 2,130.69 S1,420.46
NPV S442,613.70 S271,590.86

Net present value option 1 = Si442,613.70. Net present value option 2 = Si271,590.86
(c) Using the Excel formula =PMT(0.1,20,S444593.09,,0) the equivalent annuity of option 1 =
Si52,221.74. Using the Excel formula =PMT(0.1,20,S207271.27,,0) the equivalent annuity of
option 2 = Si31,745.96
(d) Infinite lifetime. Net present value option 1 = S700,000 + 30,000/0.1 = Si400,000. Net present
value option 2 = S100,000 S 20,000/0.1 = Si300,000. The better option is option 2.

2. (a) Excel spreadsheet CH10EX2 reproduced below.

Discount rate 15%
Year 0 1 2 3 4 5
Cashflow project A S1000 S200 400 500 600 300
Cashflow project B S500 S700 0 800 900 600
Discount factor 1 0.8696 0.7561 0.6575 0.5718 0.4972
PV project A S1,000.00 S173.91 302.46 328.76 343.05 149.15
PV Project B S500.00 S608.70 0.00 526.01 514.58 298.31
NPV project A S$50.49 IRR A 13%
NPV project B $230.20 IRR B 22%
Net present value project A = S50.49. Net present value project B = 230.20. Accept project B
(b) There is no discount rate for which both projects have the same net present value. Project B
is always better than project A. The rate for which both projects have the same net present
value is the point at which you are indifferent between project A and project B.
(c) Internal rate of return project A = 13.41%. Internal rate of return project B = 21.83%. Accept
project B as it has the highest IRR over 15%

3. Excel spreadsheet CH10EX3 reproduced below.

Discount rate 15%
NPV S£18,144.82
Year Payments Discount factor Present Value
0 S£3,000.00 1 S£3,000.00
1 S£525.00 0.987654321 S£518.52
2 S£525.00 0.975461058 S£512.12
3 S£525.00 0.963418329 S£505.79
4 S£525.00 0.951524275 S£499.55
5 S£525.00 0.939777062 S£493.38
6 S£525.00 0.928174876 S£487.29
7 S£525.00 0.916715927 S£481.28
8 S£525.00 0.905398446 S£475.33
9 S£525.00 0.894220688 S£469.47
10 S£525.00 0.883180926 S£463.67
11 S£525.00 0.872277458 S£457.95
12 S£525.00 0.8615086 S£452.29
13 S£525.00 0.850872692 S£446.71
14 S£525.00 0.840368091 S£441.19
 10.3

15 S£525.00 0.829993176 S£435.75

16 S£525.00 0.819746347 S£430.37
17 S£525.00 0.809626021 S£425.05
18 S£525.00 0.799630638 S£419.81
19 S£525.00 0.789758655 S£414.62
20 S£525.00 0.780008548 S£409.50
21 S£525.00 0.770378813 S£404.45
22 S£525.00 0.760867964 S£399.46
23 S£525.00 0.751474532 S£394.52
24 S£525.00 0.742197069 S£389.65
25 S£525.00 0.733034142 S£384.84
26 S£525.00 0.723984338 S£380.09
27 S£525.00 0.715046259 S£375.40
28 S£525.00 0.706218528 S£370.76
29 S£525.00 0.697499781 S£366.19
30 S£525.00 0.688888672 S£361.67
31 S£525.00 0.680383874 S£357.20
32 S£525.00 0.671984073 S£352.79
33 S£525.00 0.663687973 S£348.44
34 S£525.00 0.655494294 S£344.13
35 S£525.00 0.647401772 S£339.89
36 S£525.00 0.639409158 S£335.69
The cheaper option is to get the bank loan as it has a NPV of S£18,000 while the car dealers
option has a NPV of S£18,144.82

4. Excel spreadsheet CH10EX4 reproduced below.

FORESTRY PROBLEM (All on a per hectare basis)
Discount rate 0.05 Discount factor 0.952381
OPTION Year Discount CR Option PV Option Option PV Option
factor factor A A B B
Initial investment 0 1.000 1.000 ($2,000) ($2,000) ($1,500) ($1,500)
Thinning cost 6 0.746 0.197 ($1,000) ($746) $0 $0
Pruning cost 10 0.614 0.130 ($800) ($491) $0 $0
R'wood thin cost 14 0.505 0.101 $0 $0 ($2,000) ($1,010)
Revenue 14 0.505 0.101 $0 $0 $3,600 $1,818
Clearfell cost 27 0.268 0.068 $0 $0 ($2,200) ($589)
Pulpwood thin cost 27 0.268 0.068 $0 $0 $28,000 $7,500
Clearfell cost 35 0.181 0.061 ($3,000) ($544) $0 $0
Sawlog revenue 35 0.181 0.061 $64,000 $11,603 $0 $0
NPV $7,821 $6,219
EQUIVALENT ANNUITY $473 $425

(a) The present value of option A is $7,821 and the present value of option B is $6,219.
(b) The present values of the two options cannot be compared because they cover different lengths.
Option A has the higher equivalent annuity and is therefore the better option.

5. All costs assumed end of year.

Machine 1 Machine 2
Time Cost £ Cashflow £ NPV £ Cashflow £ NPV £
Now Initial Purchase S30,000 S30,000 S60,000 S60,000
Year 1 Contribution 30,000 33,000
S Fixed costs S18,000 S8,000
Net 12,000 10,000 25,000 20,833
Year 2 Contribution 45,000 49,500
S Fixed costs S18,000 S8,000
Net 27,000 18,750 41,500 28,819.44
Year 3 Contribution 50,000 66,000
+ Resale 7,000 19,000
S Fixed costs S18,000 S8,000
Net 39,000 22,569.14 77,000 44,560.19
NPV £21,319.44 £34,212.63
The NPV of machine 2 is higher hence best policy is to purchase machine 2.
 10.4

6. Excel spreadsheet CH10EX6 reproduced below.

REPLACEMENT PROBLEM: All cash flows at end of period
New Machine cost £30,000 contr./unit 2.5
Discount rate 0.2 Discount factor 0.83333333
Year of operation 1 2 3 4 5 6
Annual Output 12,000 12,000 11,500 10,800 10,000 9,000
Contribution £30,000 £30,000 £28,750 £27,000 £25,000 £22,500
Operating costs £3,400 £3,600 £3,900 £4,500 £5,400 £6,800
Resale value £27,000 £24,000 £20,000 £15,000 £9,000 £2000
Replace at age 1 2 3 4 5 6
PV contribution £25,000 £20,833 £16,638 £13,021 £10,047 £7,535
PV operating costs £2,833 £2,500 £2,257 £2,170 £2,170 £2,277
PV profit £22,167 £18,333 £14,381 £10,851 £7,877 £5,258
PV cumulative profit £22,167 £40,500 £54,881 £65,731 £73,608 £78,866
PV resale value £22,500 £16,667 £11,574 £7,234 £3,617 £670
NPV repl.policy £14,667 £27,167 £36,455 £42,965 £47,225 £49,536
Equiv.Annuity beg £14,667 £14,818 £14,422 £13,831 £13,159 £12,413

(a) The optimal replacement policy is to keep the machine for 2 years. This satisfies the firms
criterion of earning at least 20% on its investments because the NPV is greater than zero.
(b)
Annual sums
Year of operation 1 2 3 4 5 6
PV contribution £26,595 £21,879 £17,250 £13,328 £10,153 £7,517
PV op. costs £3,014 £2,626 £2,340 £2,221 £2,193 £2,272
Cumulative profit £23,581 £42,835 £57,745 £68,851 £76,811 £82,057
PV resale £22,213 £16,244 £11,137 £6,872 £3,392 £620
NPV repl. policy £15,794 £29,079 £38,881 £45,723 £50,203 £52,677
Equivalent annuity £15,794 £15,861 £15,382 £14,719 £13,989 £13,200

The optimal replacement policy does not change. It is still best to keep the machine for 2 years.

7. Excel spreadsheet CH10EX7 reproduced below.

REPLACEMENT PROBLEM: All cash flows end of period
New Machine cost i35,000
Discount rate 0.18 Discount factor 0.847457
Year of operation 1 2 3 4 5
Op. cost END/YR i3,500 i3,600 i4,000 i6,000 i8,000
Resale END/YR i31,000 i26,000 i20,000 i12,000 i3,000
Replace at age 1 2 3 4 5
PV operating cost i2,966 i2,585 i2,435 i3,095 i3,497
PV cum.oper.cost i2,966 i5,552 i7,986 i11,081 i14,578
PV resale value i26,271 i18,673 i12,173 i6,189 i1,311
NPV repl.policy i11,695 i21,879 i30,813 i39,891 i48,266
Equiv.Annuity beg i11,695 i11,843 i12,010 i12,567 i13,080
PV discount factor 0.847457 0.718184 0.6086308 0.5157888 0.437109
Cap.rec.factor beg 1 0.541284 0.3897659 0.31503277 0.270998
REPL. OF CURRENT MACHINE: Current resale value i13,000
Age of machine 5 6 7 8 9
Overhaul cost BEG/YR i11,000
Op. cost END/YR i6,500 i7,200 i8,500 i10,100 i12,500
Resale END/YR i22,000 i18,000 i12,000 i6,000 i1,200
As BEG/YR costs
Op. cost + overhaul i16,508 i6,102 i7,203 i8,559 i10,593
Resale value i13,000 i22,000 i18,000 i12,000 i6,000
PV next resale val. i18,644 i15,254 i10,169 i5,085 i1,017
PV total cost i10,864 i12,847 i15,034 i15,475 i15,576

(a) The optimal replacement interval for the new machine is 1 year since this has the lowest
equivalent annuity of i11,695.
(b) The guillotine should be kept for another year until the end of year 5 and then replaced.
 10.5

8. Excel spreadsheet CH10EX8 reproduced below.

SILICONE PLASTICS LTD
OPTIMAL REPLACEMENT PERIOD FOR NEW MACHINE
New cost $246,000 Output/year 140000 kg
Raw material cost/kg $3.64 Discount rate 18 %
Labour cost/hour $40.00 Discount factor 0.8474576
Fringe Benefits 20 %
Output/hour 78 kg
Year of operation 1 2 3 4 5 6
Down time hours 192 192 192 202 212 226
Reject percentage 0.80 0.80 0.80 0.80 0.96 1.28
Repair cost $0 $0 $102 $203 $413 $826
Overhaul $4,000 $4,000
Regular time output 133706 133706 133706 132932 131945 130441
Overtime required 81.4 81.4 81.4 91.4 104.3 124.2
Resale value $216,000 $198,000 $183,000 $168,000 $132,000 $96,000
COST COMPUTATIONS
DownStime cost $9,216 $9,216 $9,216 $9,696 $10,176 $10,848
Material cost rejects $4,109 $4,109 $4,109 $4,109 $4,939 $6,606
Repair and Overhaul $0 $0 $4,102 $203 $413 $4,826
Overtime cost $5,857 $5,857 $5,857 $6,577 $7,508 $8,940
Total yearly cost $19,183 $19,183 $23,285 $20,586 $23,036 $31,220
REPLACE AFTER YEAR 1 2 3 4 5 6
PV yearly cost $16,257 $13,777 $14,172 $10,618 $10,069 $11,565
Cumulative PV cost $16,257 $30,033 $44,205 $54,823 $64,893 $76,457
PV resale value $183,051 $142,201 $111,379 $86,653 $57,698 $35,561
NPV replacement policy $79,206 $133,833 $178,826 $214,171 $253,194 $286,896
Equivalent Annuity $79,206 $72,442 $69,700 $67,471 $68,615 $69,514
(beg. of period) lowest
REPLACEMENT 6SYEAR OLD MACHINE Current Resale Value $64
Operation year 1992 1993 1994 1995 1996 1997
DownStime hours 212 233 260 282 312 340
Reject percentage 1.00 1.20 1.60 2.20 3.00 4.00
Repair cost $2,360 $4,720 $9,440 $18,880 $37,760 $75,520
Overhaul $3,000
Regular time output 131,892 130,007 127,408 124,953 121,661 118,310
Overtime required 105.0 129.7 164.1 197.3 242.6 290.1
Resale Value $40 $14 $0 $0 $0
COST COMPUTATIONS
DownStime hours $10,176 $11,184 $12,480 $13,536 $14,976 $16,320
Material cost rejects $5,147 $6,189 $8,284 $11,458 $15,747 $21,199
Repair and Overhaul $2,360 $4,720 $12,440 $18,880 $37,760 $75,520
Overtime cost $7,561 $9,338 $11,815 $14,209 $17,468 $20,890
Total yearly cost $25,244 $31,430 $45,019 $58,083 $85,950 $133,930
Incremental op. cost (PV) $21,393 $26,636 $38,152 $49,223 $72,839 $113,500
Loss in resale value (PV) $30 $28 $14 $0 $0 $0
Incremental cost $21,423 $26,664 $38,166 $49,223 $72,839 $113,500

(a) Optimal replacement period for new machine is 4 years.

(b) Replace old machine at the beginning of 1996.
 10.6

9. Excel spreadsheet CH10EX9 reproduced below.

KIWI WINES
Capacity of warehouse (bottles) 360000 Grapes available 240 tonnes
Price of grapes/tonne $1,800 Grape/wine ratio 920 litres
Grape processing cost/tonne $850 Bottle volume 0.7 litre
Bottling cost/bottle $0.36 Equiv. bottles 315429
Case cost/12 bottles $1.18 Fixed cost $43,600
Annual tending cost/bottle $0.21 Desired rate of return 0.18
Implied discount factor 0.8474576
W'house cost $300,000 Useful life 20
(a) Evaluation of optimal age to sell
Year 0 1 2 3 4 5 6
Selling price $72.00 $86.00 $110.00 $136.00 $148.00 $156.00 $160.00
Max. bottle quantity 0 360,000 180,000 120,000 90,000 72,000 60,000
Quantity wine aged 0 315,429 180,000 120,000 90,000 72,000 60,000
Quantity wine new 315,429 0 135,429 195,429 225,429 243,429 255,429
REVENUE associated with a given bottling year:
Revenue aged wine 0 2,260,575 1,650,000 1,360,000 1,110,000 936,000 800,000
Revenue new wine 1,892,574 0 812,574 1,172,574 1,352,574 1,460,574 1,532,574
PV revenue 1,892,574 1,915,741 1,997,578 2,000,312 1,925,100 1,869,708 1,828,919
COSTS associated with a given bottling year:
PV aging cost 0 56,136 59,181 54,792 50,842 47,283 44,070
PV Case cost 31,017 26,286 26,029 26,399 26,732 27,032 27,303
PV costs 31,017 82,421 85,210 81,191 77,574 74,315 71,373
PV contribution 1,861,557 1,833,320 1,912,368 1,919,121 1,847,526 1,795,393 1,757,547
per bottling year
NPV over horizon 9,964,442 9,813,296 10,236,421 10,272,570 9,889,336 9,610,286 9,407,702
Difference with base S151,146 271,979 308,128 S75,106 S354,156 S556,740
Conclusion: Best number of years to age is 3
(b) Evaluation of warehouse project
Construction cost 300,000
PV operating cost 233,380
PV w'house cost 533,380
NPV of project S684,526 S261,400 S225,252 S608,485 S887,535 S1,090,119
Conclusion: Build warehouse

(a) Best number of years to age the wine is 3

(b) The warehouse should be built

10. The tools of this chapter should be applied to such issues also, however with a number of important
provisos, and only as one of several measures looked at. If various alternatives provide the same
total benefits, both tangible and intangible, then present value calculations of all costs will allow
assessing the cost effectiveness of the various alternatives. If the benefits differ, then it may be
possible to combine present value calculations of costs with appropriate measures of the various
benefits, by computing rations of benefits and costs. This will again allow a ranking or partial ranking
of alternatives. It is not recommended to try to convert highly intangible benefits or costs into
monetary terms. The analyst open her/himself to all sorts of justified criticism, such as the
arbitrariness of the procedure, the implied use of the world view of a given group of society which
may not be valid for other segments of the society, often the obvious nonsensical value judgments
implied by the procedure (such as valuing an 11th century church at its token fire insurance value),
etc. It is better, and more honest, for the analyst to leave such items out of the numeric evaluation
and include their relevance/impact/effect in qualitative terms in the final report, leaving it up to the
political process to sort out such thorny issues, where in fact they belong.
There are also issues of intergenerational concerns that enter here, particularly for the valuation
of the irreversible destruction of environments, fauna or flora, and the choice of discount rate. Is it
ethically defensible to value the destruction of scenic beauty, a wildlife habitat or archaeological or
cultural site that will be lost to all future generations, with a dollar amount? What does such valuation
actually mean or imply? For example, is it defensible to consider fishing policies that have a high
risk of wiping out a given species of whales and assess that loss by a given dollar value? Even if
a fund is set up, equivalent to that valuation, to compensate future generation for the loss of ever
 10.7

seeing this species of whales again, is this a fair trade? Similarly, can we really justify loading future
generations for 1000 years or more with the wastes, in particular nuclear wastes, generated by our
current waste and growth obsessed society?
These are very important issues that society should address in a serious and responsible
manner, rather than with just political expediency and shortSterm horizons. This is particularly
important in the choice of discount rate, since even a low discount rate of 3% implies that any
assets/resources/events occurring 100 years in the future are only valued at about 5% of their
nominal value. Hence anything that happens three or so generations in the future is basically
ignored.