Chapter 6

Making Investment Decisions

with the Net Present Value Rule
Applying NPV Rule
Rule 1: Only Cash Flow Is Relevant
NPV depends on future cash flows (not accounting income)

Accounting income is intended to show how well the company is performing

but should not be used to compute NPV

When performing a capital budgeting calculation, always discount CFs not

earnings.
 Earnings do not represent real money (you can’t spend out of earnings)

Difference between accounting income and cash flow is due to the following
accounting adjustments:
 Capital Expenses: Deducting current expenses (through depreciation) instead
of capital expenses
 Depreciation is a non-cash expense
 Matching Principle
Capital Expenses
 If a firm pays a huge lump sum on a certain investment, we do not conclude
that the firm is performing poorly (even though a lot of cash is paid) 
Instead of deducting capital expenditure as it occurs, the accountant
depreciates the outlay over several years
 This makes sense when judging firm performance but will be problematic when
calculating NPV

 Example: A 2 year investment costs $2,000 and is expected to provide a cash

flow of $1,500 and $500 over the next 2 years

 Given a discount rate of 10%, calculating NPV using accounting income yields $41.23 > 0  This
wrongly suggests that we should accept this project
 Using CFs, NPV would be negative given any positive discount rate  Project should be rejected
 To determine cash flow from income, add back depreciation and subtract capital expenditure
Matching Principle
 Matching principle – GAAP says to show revenue when it accrues and
match the expenses required to generate the revenue
 Revenue is usually recognized at the time of sale, which is not necessarily the
same as the time of collection.
 Matching principle: Determine revenues and match those revenues with the
costs associated with producing them

 Example: We manufacture a product for $1,000 (t = -1) and then sell it on credit
for $1,200 (Sale occurs at t = 0 but cash is received at t = 1)
 It would be misleading to say that the firm was losing at t = -1 (CF was negative) or
that it was extremely profitable at t = 1 (CF was positive) => the accountant
recognizes revenues and costs at the time of sale.
 However, the figures shown on the income statement may not be at all representative
of the actual cash inflows and outflows that occurred during a particular period.

2-4
Incremental Cash Flows
Rule 2: Estimate Cash Flows on an Incremental Basis:

 It is not enough to use CFs  In calculating the NPV of a project,

only cash flows that are incremental to the project should be used

 The cash flows that should be included in a capital budgeting

analysis are those that will only occur if the project is accepted
These cash flows are called incremental cash flows
 Incremental CFs are the changes in the firm’s CFs that occur as a
direct consequence of accepting the project
 This is the difference between CFs of the firm with the project and
CFs of the firm without the project
Incremental Cash Flows
 Relevant
 Taxes: Cash flows should be estimated on an after-tax basis
 Opportunity costs
 Incidental effects (Side Effects or Externalities)
 E.g. erosion or synergy
 Salvage Value
 At end of project’s life, if equipment is sold  taxes must be paid on the difference between
the sale price and the book value of the asset.
 Salvage Value (net of any taxes) represents a positive cash flow
 Allocated Overhead Costs
 Overheads include such items as supervisory salaries, rent, heat, light, etc… These costs
may be related to several projects at the same time
 However, overhead costs should be viewed as a cash outflow of a project only if it is an
incremental cost of the project  It is only relevant if it includes only the extra expenses
that would result from the project

 Irrelevant
 Sunk costs
6 8-6
Incremental Cash Flows
 A sunk cost is a cost that has already occurred

 Sunk costs were incurred in the past and cannot

be changed by the decision to accept or reject
the project

 Sunk costs are not incremental Cash outflows

(They are irrelevant)
8-7
Incremental Cash Flows
 Example: If a company is currently evaluating
the NPV of establishing a line of chocolate
milk. As part of the evaluation, the company
had paid a consulting firm $100,000 to
perform a test-marketing analysis. This
expenditure was made last year. Is this cost
relevant for the capital budgeting decision now
confronting the management of the company?

8-8
Incremental Cash Flows
 By taking project A, the firm forgoes other opportunities for
using its assets (such as investing in project B)

 The lost revenues from the alternative investments (Project B)

are called the opportunity cost

 Opportunity costs do matter. Just because a project has a positive

NPV, that does not mean that it should also have automatic
acceptance. Specifically, if another project with a higher NPV
would have to be passed up, then we should not proceed.

8-9
Problem
 A firm is looking at setting up a new manufacturing plant in South
Park to produce garden tools. The company bought some land six
years ago for $6 million in anticipation of using it as a warehouse
and distribution site, but the company has since decided to rent
these facilities from a competitor instead. If the land were sold
today, the company would net $6.4 million. The company wants to
build its new manufacturing plant on this land; the plant will cost
$14.2 million to build, and the site requires $890,000 worth of
grading before it is suitable for construction. What is the proper
cash flow amount to use as the initial investment in fixed assets
when evaluating this project?
 Answer: $21,490,000

8-10
Incremental Cash Flows
 The side effects of the proposed project on
other parts of the firm matter in determining
the incremental CFs

 A side effect is classified as either erosion or

synergy:
 Erosion occurs when a new product reduces the
sales and, hence, the CFs, of existing products
 Synergy occurs when a new product increases the
CFs of existing products
8-11
Incremental Cash Flows
 Example: Suppose a car company
determined that the NPV of introducing a
new convertible sports car is $100 M.
However, half of the customers are
transfers from the sedan. The lost sedan
sales have an NPV of -$150 M (This is an
erosion)
=> The true NPV is -$50 M
8-12
Problem
 A firm currently sells 30,000 motor homes per year at $53,000
each, and 12,000 luxury motor coaches per year at $91,000
each. The company wants to introduce a new portable camper
to fill out its product line; it hopes to sell 19,000 of these
campers per year at $13,000 each. An independent consultant
has determined that if the firm introduces the new campers, it
should boost the sales of its existing motor homes by 4,500
units per year, and reduce the sales of its motor coaches by
900 units per year. What is the amount to use as the annual
sales figure when evaluating this project?

 Answer: $403,600,000
8-13
Depreciation
 The depreciation expense used for capital budgeting
should be the depreciation schedule required by the
IRS for tax purposes

 Depreciation itself is a non-cash expense;

consequently, it is only relevant because it affects taxes

 Depreciation tax shield = DT

 D = depreciation expense
 T = tax rate

10-14
Computing Depreciation
 Straight-line depreciation
 Dep = (Initial cost – salvage) / number of years

 MACRS (Modified Accelerated Cost Recovery

system)
 Multiply percentage given in table by the initial cost
 Depreciate to zero

10-15
Computing Depreciation
 A piece of newly purchased industrial equipment costs
$1,080,000 and is classified as seven-year property
under MACRS. Calculate the annual depreciation
allowances and end-of-the-year book values for this
equipment.
  Year Beginning Book Value MACRS   Depreciation Ending Book value
  1 $1,080,000.00 0.1429   $154,332.00 $925,668.00
  2 925,668.00 0.2449   264,492.00 661,176.00
  3 661,176.00 0.1749   188,892.00 472,284.00
  4 472,284.00 0.1249   134,892.00 337,392.00
  5 337,392.00 0.0893   96,444.00 240,948.00
  6 240,948.00 0.0892   96,336.00 144,612.00
  7 144,612.00 0.0893   96,444.00 48,168.00
  8 48,168.00 0.0446   48,168.00 0 10-16
 MACRS Tax Depreciation Schedules
Tax depreciation
allowed under the
modified
accelerated cost
recovery system
(MACRS)
(Figures in percent of
depreciable investment)
After-tax Salvage Value
 If the salvage value is different from the book value of the
asset, then there is a tax effect
 Under current tax laws, the company is required to pay
taxes at the ordinary income tax rate on the difference
between the sale price (Market Value) and the book value.
 Taxes must be paid because the difference between the
MV and the BV is “excess” depreciation and it must be
recaptured when the asset is sold.
 Book value = initial cost – accumulated depreciation
 After-tax salvage = MV – T(MV – BV)

10-18
Problem
 An asset used in a four-year project falls in the five-
year MACRS class for tax purposes. The asset has an
acquisition cost of $7,900,000 and will be sold for
$1,400,000 at the end of the project. If the tax rate is
35%, what is the after-tax salvage value of the asset?
Year MACRS %
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
10-19
Problem
 Consider an asset that costs $548,000 and is
depreciated straight-line to zero over its eight-year
tax life. The asset is to be used in a five-year project;
at the end of the project, the asset can be sold for
$105,000. If the relevant tax rate is 35%, what is the
after-tax cash flow from the sale of this assets?

8-20
Inflation and Capital Budgeting
Rule 3 - Treat Inflation Consistently
In capital budgeting, one must compare real cash flows
discounted at real rates or nominal cash flows discounted at
nominal rates.

It is important to maintain consistency:

 Nominal CFs must be discounted at the nominal rate
 Real CFs must be discounted at the real rate
 Both approaches always yield the same result => choose
the approach that is simpler
 Inflation and Interest Rates
 Real rate of interest – change in purchasing power (Adjusted for inflation)
 The real rate on an investment is the percentage change in how much you can buy with your
dollars  the percentage change in your buying power.

 Nominal rate of interest – quoted rate of interest, change in purchasing power and
inflation (Unadjusted for inflation)
 The nominal rate on an investment is the percentage change in the number of dollars you
have.

 Example: Suppose inflation rate is 5%. An investment is available that will be worth
$115.50 in one year. It costs $100 today.
FV = PV (1+r) => r = 15.5%  nominal return

 With 5% inflation, each of the $115.50 nominal dollars is worth 5% less in real terms =>
The real dollar value of the investment in one year is:
 115.5/1.05 = $110 => r = 10%  Real return (Fisher Effect gives same answer)
5-22
The Fisher Effect
 The Fisher Effect defines the relationship between real rates, nominal
rates, and inflation.
 (1 + R) = (1 + r)(1 + h), where
 R = nominal rate
 r = real rate
 h = expected inflation rate
 Approximation
 R=r+h

 Example: If we require a 10% real return and we expect inflation to be

8%, what is the nominal rate?
 R = (1.1)(1.08) – 1 = .188 = 18.8%
 Approximation: R = 10% + 8% = 18% 5-23
Inflation and Capital Budgeting
 Capital budgeting requires data on cash flows as well as on interest
rates.
 Like interest rates, cash flows can be expressed in either nominal or
real terms
 A nominal CF refers to the actual dollars to be received (or paid)
 A real CF refers to the cash flow’s purchasing power

 Example: Suppose inflation rate is 6%. Suppose you expect to get

$1.36 million after 4 years.
 $1.36 million is a nominal cash flow
 The purchasing power of $1.36 million in four years is determined by deflating the
$1.36 million at 6% for 4 years
 (1.36/(1.06)^4) = $1.08 million
 The $1.08 is the real CF that you will receive after 4 years.

8-24
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

1 + inflation rate
Inflation
Example - Nominal figures

Year Cash Flow PV @ 15%

0 - 100  100
1 35  1.10 = 38.5 38.5
1.15
 33.48
2 50  1.10 2 = 60.5 60.5
1.152
 45.75
3 30  1.103 = 39.9 39.9
1.153
 26.23
$5.5
Inflation
Example - continued
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

1 + inflation rate
1.15
  1  .045
1.10
Inflation
Example - Real figures

Year Cash Flow PV@4.50%

0  100  100
1 35 35
1.045
= 33.49
2 50 50
1.0452
= 45.79
3 30 30
1.0453
= 26.29
= $5.5
 Rule 4: Separate Investment and Financing
Decision
Question: How should you treat the proceeds from the debt issue and the interest and
principal payments on the debt?
Answer: You should neither subtract the debt proceeds from the required investment
nor recognize the interest and principal payments on the debt as cash outflows

Regardless of the actual financing, firms typically calculate a project’s cash flows
under the assumption that the project is financed only with equity  Treat all CFs
required for project as coming from stockholders and all cash inflows as going to them
 Adjustments for debt financing are generally reflected in the discount rate, not CFs

Allows for the separation of the investment decision from the financing decision
 Assuming all equity financing, analyze whether project has positive NPV
 Then, if project is valuable, perform a separate analysis of the best financing strategy
Changes in NWC
 What is working capital?
 Current assets – current liabilities
 Net investment in short term assets

 Why does it increase?

 Essentially, you are making an investment in working capital
(negative CF  The increase of NWC is viewed as a cash
outflow)

 At end of project – usually assumed to be completely

recovered
 Increases then decreases
 Decrease of NWC at end of project is viewed as a cash inflow

8-30
 Estimating Cash Flows
 Cash Flow from Operations
 OCF = EBIT – Taxes + Depreciation
 OCF = Net income + depreciation (when there is no interest expense)

 CF from capital investment and disposal = Fixed Assets Sold – Fixed Assets Bought
 Don’t forget salvage value (after tax, of course)

 CF from changes in working capital = Beginning NWC - Ending NWC

 Net Cash Flow = OCF + CF from capital investment and disposal + CF

from changes in working capital

8-31
IM&C’s Project
 The firm is analyzing a proposal for marketing their product as a garden
fertilizer.

 Project requires an investment of $10M in plant and machinery.

 This machinery can be dismantled and sold for net proceeds estimated at
$1.949M in year 7  This is your forecast of the plant’s salvage value.

 The capital investment is depreciated over 6 years to an arbitrary salvage

value of $500,000, which is less than your forecast of salvage value 
Straight line depreciation is used.

 Tax rate is 35%; Nominal Discount Rate = 20%

 The goal is to obtain projections of CF and eventually calculate NPV

8-32
IM&C’s Project
 The forecasts are shown in the below table. All entries are in nominal
terms. Numbers are reported in $1,000s.
                   
    0 1 2 3 4 5 6 7
1 Sales   523 12,887 32,610 48,901 35,834 19,717  
2 Cost of goods sold   837 7,729 19,552 29,345 21,492 11,830  
3 other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772  
4 Depreciation   1,583.33 1,583.33 1,583.33 1,583.33 1,583.33 1,583.33  
5 Pretax profit (1-2-3-4) -4,000 -4,097.33 2,364.67 10,143.67 16,508.67 11,147.67 4,531.67  
6 Taxes -1400 -1,434.07 827.63 3,550.28 5,778.03 3,901.68 1,586.08  
7 Net Income (5-6) -2,600 -2,663.26 1,537.04 6,593.39 10,730.64 7,245.99 2,945.59  
8 OCF (1-2-3-6) -2,600 -1,079.93 3,120.37 8,176.72 12,313.97 8,829.32 4,528.92  
                   
9 NWC   550 1,289 3,261 4,890 3,583 2,002 0
CF from changes in
10   -550 -739 -1972 -1629 1307 1581 2002
working capital

 Dep = (Initial cost – salvage) / number of years = (10,000 – 500)/6 =

$1,583.33
8-33
 IM&C’s Project
 Dep. / year = $1583.33
 Accumulated Depreciated after 6 years = $1583.33 * 6 = $9,500
 Book Value at end of 7 years = $10,000 - $9,500 = $500 (This was already given)

 After-tax salvage = MV – T(MV – BV) = $1,949 – 0.35($1,949 - $500) = $1,441.85

                   
    0 1 2 3 4 5 6 7
1 OCF -2600 -1079.93 3,120 8,177 12,314 8,829 4,529  
CF from capital investment
2 -$10,000             $1,441.85
and disposal
CF from changes in
3   -550 -739 -1,972 -1,629 1,307 1,581 2002
working capital
4 CFFA (1+2+3) -12,600.00 -1,629.93 2,381.37 6,204.72 10,684.97 10,136.32 6,109.92 3,443.85

1,630 2,381 6,205 10,685 10,136

NPV  12,600     
1.20 1.20 2
1.20 1.20 1.20 5
3 4

6,110 3,444
   3,520 or $3,520,000
1.20 1.20
6 7
8-34
The Baldwin Company

 In 2007, the Baldwin Company investigated the

market potential of brightly colored bowling balls.

 The results were better than expected

 Now, the company is considering investing in a

machine to produce these bowling balls

 The goal is to obtain projections of CF

8-35
The Baldwin Company
 Costs of test marketing (already spent): $250,000  Sunk cost

 Current market value of proposed factory site (building and land where the bowling
balls would be manufactured which the company owns): $150,000

 Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-year)

 Machine has estimated MV at end of 5 years of $30,000

 Increase in net working capital: $10,000

 Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000,
10,000, 6,000

8-36
The Baldwin Company
 Price during first year is $20; price increases 2% per
year thereafter.
 Production costs during first year are $10 per unit
and increase 10% per year thereafter.
 Annual inflation rate: 5%
 The appropriate incremental corporate tax rate in the
bowling bowl project is 34%
 Working Capital: initial $10,000 and it changes with
sales
8-37
The Baldwin Company (NWC)
 Like any other manufacturing firm, Baldwin finds
that it must make an investment in NWC
 It will purchase raw materials before production and sale =>
Inventory increases
 Its credit sales will generate AR

 NWC is forecasted to rise in the early years of the

project but be completely recovered by the end of
the project’s life
 All inventory will be sold at the end
 All AR are collected

8-38
The Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Year-end Book Value 80.00 48.00 28.80 17.28 5.76

(4) Opportunity cost –150.00 150.00

(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) CF from changes –10.00 –6.32 –8.65 3.75 21.22
in working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)] 8-39
The Baldwin Company (Salvage Value)
 Under current tax laws, the company is required to pay taxes
at the ordinary income tax rate on the difference between the
sale price ($30,000) and the book value ($5,760)

 Suppose at the end of the project the company sold the

machine for $30,000. However, at the end of the 5th year the
BV of the machine is $5,760.

 Tax liability = 0.34 x (30,000 – 5760) = 8241.6 => The after

tax salvage value of the equipment would be 30,000 – 8241 =
$21,758.4

8-40
The Baldwin Company (Salvage Value)
 Taxes must be paid because the difference
between the MV and the BV is “excess”
depreciation and it must be recaptured when
the asset is sold.

 In this case, Baldwin would have over

depreciated the asset by 30,000 – 5760 =
$24,240
8-41
The Baldwin Company
 The investment outlays for the project consist of 3
parts:
1) The Bowling Ball Machine
2) The opportunity cost of not selling the warehouse
and land
3) The investment in NWC

 The total CF (outflow at time 0) from the above 3

investments is -$260,000

8-42
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Year-end Book Value 80.00 48.00 28.80 17.28 5.76

(4) Opportunity cost –150.00 150.00

(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) CF from changes –10.00 –6.32 –8.65 3.75 21.22
in working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]
8-43
At the end of the project, the warehouse is unhampered, so we can sell it if we want to.
The Baldwin Company
 The next step is to calculate the income  Although
we are ultimately interested in CF (not income), the
income calculation is needed to determine taxes.

 Note: Depreciation is based on the Modified

Accelerated Cost Recovery system (MACRS).
 Each Asset is assigned a useful life under MACRS, with
an accompanying depreciation schedule
 To determine depreciation in each year => multiply the
percentages in the depreciation schedule by the asset’s
cost
8-44
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90

Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.

8-45
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84

Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
8-46
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
(10) Depreciation 20.00 32.00 19.20 11.52 11.52

Depreciation is calculated using the Accelerated Year ACRS %

Cost Recovery System (shown at right). 1 20.00%
Our cost basis is $100,000. 2 32.00%
Depreciation charge in year 4 3 19.20%
= $100,000×(.1152) = $11,520. 4 11.52%
5 11.52%
6 5.76%
Total 100.00%
8-47
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
(11) Income before taxes 30.00 43.20 85.32 67.58 30.54
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(13) Net Income 19.80 28.51 56.31 44.60 20.16

8-48
Incremental After Tax Cash Flows
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(1) Sales   $100.00 $163.20 $249.72 $212.20 $129.90

Revenues
(2) Operating   -50.00 -88.00 -145.20 133.10 -87.84
costs
(3) Taxes   -10.20 -14.69 -29.01 -22.98 -10.38

(4) OCF   39.80 60.51 75.51 56.12 31.68

(1) – (2) – (3)
(5) Total CF of –260.   –6.32 –8.65 3.75 192.98
Investment
(6) Net CF –260. 39.80 54.19 66.86 59.87 224.66
[(4) + (5)]

$39.80 $54.19 $66.86 $59.87 $224.66

NPV  $260   2
 3
 4

(1.10) (1.10) (1.10) (1.10) (1.10) 5
8-49
NPV  $51.588
NPV of Baldwin Company
CF0 –260 F3 1

CF1 39.80 CF4 59.87 I 10

F1 1 NPV 51.588
F4 1

CF2 54.19
CF5 224.66
F2 1
F5 1
CF3 66.86
8-50
The Investment Timing Decision
 Problem 1: Investment Timing Decision
 Should you invest now or in the future?
 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

NPV0 = NPVt / (1+r)t

 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?

• Before year 4, net future value increases by more than 10%

 Gain in value is greater than the cost of capital.
Answer: Year 4
• After year 4, gain in value is less than the cost of capital
 Delaying the project further reduces shareholder wealth.
 The Choice between Long- and Short-Lived Equipment
Problem 2: Should the firm save money today by installing cheaper machinery
that will not last as long?
 Assuming both machines have identical capacity and do exactly the same job
 A simple application of the NPV rule suggests taking the machine whose costs
have the lower present value  However, this choice might be a mistake since the
lower cost machine may need to be replace before the higher cost machine.
 Solution: Compare the cost of the 2 machines on a per-period basis => Calculate
the equivalent annual cost (EAC) to compare the cost per period of the 2
machines

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 cost (annuity) =
annuity factor
Equivalent Annual Cash Flows
Example
Given the following COSTS from operating two machines and a 6%
cost of capital, which machine has the lower equivalent annual cost?
(Note all numbers in the below chart are outflows)

Year
Mach. 0 1 2 3 NPV@6% E.A.C.
A 15 5 5 5 28.37 10.61
B 10 6 6 21.00 11.45
 Would you rather make annual lease payments of 10.61 or 11.45?  Choose
A since its EAC is lower
The Choice between Long- and Short-Lived Equipment:
Replacement Chain Approach
 Consider a factory that must have an air
cleaner that is mandated by law. There are two
choices:
 The “Cadillac cleaner” costs $4,000 today, has
annual operating costs of $100, and lasts 10 years.
 The “Cheapskate cleaner” costs $1,000 today, has
annual operating costs of $500, and lasts 5 years.
 Assuming a 10% discount rate, which one
should we choose?
8-55
The Choice between Long- and Short-Lived Equipment:
Replacement Chain Approach
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 – 4,000 CF0 –1,000

CF1 –100 CF1 –500

F1 10 F1 5

I 10 I 10

NPV –4,614.46 NPV –2,895.39

At first glance, the Cheapskate cleaner has a higher NPV. 8-56
The Choice between Long- and Short-Lived Equipment:
Replacement Chain Approach
 Application of the NPV rule can lead to the wrong
decision.
 It overlooks the fact that the Cadillac cleaner lasts
twice as long.
 When we incorporate that, the Cadillac cleaner is
actually cheaper (i.e., has a higher NPV).

8-57
The Choice between Long- and Short-Lived Equipment
Two Approaches

Equivalent Annual Cost

Replacement Chain Approach

 Repeat projects until they begin and end at the
same time.
 Compute NPV for the “repeated projects.”

8-58
Replacement Chain Approach
The Cadillac cleaner time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100
-100
0 1 2 3 4 5 6 7 8 9 10

The Cheapskate cleaner time line of cash flows

over ten years:
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0 1 2 3 4 5 6 7 8 9 10
8-59
Replacement Chain Approach
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 –4,000 CF0 –1,000
CF1 –500
CF1 –100
F1 4
F1 10 CF2 –1,500
I 10 F2 1
CF3 –500 I 10
NPV –4,614
F3 5 NPV –4,693
8-60