Principles of

Chapter 6 Corporate Finance

Tenth Edition

Making Investment
Decisions With the
Net Present Value
Rule

McGraw-Hill/Irwin
 6-2

Topics Covered
Applying the Net Present Value Rule
IM&C Project
Investment Timing
Equivalent Annual Cash Flows
 6-3

Applying the Net Present Value Rule

Rule 1: Only Cash Flow is Relevant

Accounting income v.s Cash flows

 Rule 1: Only Cash Flow is Relevant 6-4

 Capital Expenses
− Accounting
− Accountant depreciates the capital expenditure over
several years
− Cash flows
− Deducting capital expenditure when it occurs

To go from accounting income to cash flow, you need:

1. to add back depreciation (which is not a cash outflow)
2. to subtract capital expenditure (which is a cash outflow)
 Rule 1: Only Cash Flow is Relevant 6-5

 Working Capital
− Accounting
− Show Profit as it is earned
− Cash flows
− Receive cash or pay bills

− To go from the figure for income to the actual cash

flows, you need:
− to add back these changes in inventories
− to add back these changes in receivables
 Rule 1: Only Cash Flow is Relevant 6-6

 Working Capital: The most common

mistakes:
1. Forgetting about working capital entirely.
2. Forgetting that working capital may change during the
life of the project
3. Forgetting that working capital is recovered at the end
of the project.
 Rule 2: Estimate Cash Flows on an 6-7

Incremental Basis

 Include Taxes
 Do not confuse average with incremental payoffs
 Should not throw good money after bad? should not invest more
money in a losing division?
 No, occasionally, turnaround opportunities may exist in which incremental NPV
from investing in a loser is strongly positive.

 Always throw good money after good?

 No, A division with outstanding past profitability may run out of good investment.

 Project of repairing a railroad bridge. The railroad only continue to

operate with the bridge. Incremental NPV of the repair project = all
benefits of operating the railroad.
 Rule 2: Estimate Cash Flows on an 6-8

Incremental Basis

 Include all incidental effects

 Project leads to cut in sales of remainder of the firm’s business.
 Project helps the firm’s existing business.
 Forecast Sales Today and Recognize After-Sales Cash Flows
to come Later
 Should forecast all incremental cash flows generated by the project.
 Sometimes these CF last for decades: (ex: GE engine project  cash
flows from services and spare parts later decades).
 Rule 2: Estimate Cash Flows on an 6-9

Incremental Basis
 Include opportunity costs
 The proper comparison “with and without the project”
 Comparing “before” v.s “after”
 From there, decide if cost of a resource is opportunity cost or not
 Forget sunk costs
 Beware of allocated overhead costs
 Only extra expenses that would result from the project are relevant
 Remember salvage value
 Sale price (+) /or Shut down costs (-)
 Tax
 6-10

Inflation
Rule 3 - Treat Inflation Consistently

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
 6-11

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+ inflation rate 1
 6-12

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 + inflation rate 1
1 . 15
  1  . 045
1 . 10
 6-13

Inflation
Example - nominal figures

Year Cash Flow PV @ 15%

0 - 100  100
1 35  1.10 = 38.5 138.15.5  33.48
2 50  1.10 2 = 60.5 160.15.52  45.75
3 30  1.10 3 = 39.9 139.15.93  26.23
$5.5
 6-14

Inflation
Example - real figures

Year Cash Flow PV@4.50%

0 - 100  100
1 35 35
1.045
= -33.49
2 50 50
1.045 2
= 45.79
3 30 30
1.045 3
= 26.29
= $5.5
 6-15

Rule 4–Separate Investment and Financing Decisions

 focuses on the project cash flows, not the cash flows

associated with alternative financing schemes
 to separate the analysis of the investment decision from that of
the financing decision
 First, you ask whether the project has a positive net present value,
assuming all-equity financing.
 Then, if the project is viable, you can undertake a separate analysis of
the best financing strategy
 Solutions:
 neither subtract the debt proceeds from the required investment nor
recognize the interest and principal payments on the debt as cash
outflows.
 view the project as if it were all-equity-financed, treating all cash
outflows required for the project as coming from stockholders and all
cash inflows as going to them
 6-16

Example: IM&C’s Guano Project

Example
 Invest $10 mil
 Net sales (salvage value) in year 7: $1.949 mil.
 Depreciate 6 years, salvage value (book): $500,000
 Depreciation amount = $9,5 mil
 Other given information (next page)
 6-17

Example: IM&C’s Guano Project

Revised projections ($1000s) reflecting inflation.
Straight-line depreciation.

Accounting information
Period
0 1 2 3 4 5 6 7
1 Capital Investment 10,000 (1,949)
2 Accumulated depreciation 1,583 3,167 4,750 6,333 7,917 9,500 -
3 Year-end book value 10,000 8,417 6,833 5,250 3,667 2,083 500 -
4 Working capital 550 1,289 3,261 4,890 3,583 2,002 -
5 Total book value (3+4) 10,000 8,967 8,122 8,511 8,557 5,666 2,502 -
6 Sales 523 12,887 32,610 48,901 35,834 19,717
7 Cost of goods sold 837 7,729 19,552 29,345 21,492 11,830
8 Other Costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
9 Depreciation 1,583 1,583 1,583 1,583 1,583 1,583
10 Pretax profit (6-7-8-9) (4,000) (4,097) 2,365 10,144 16,509 11,148 4,532 1,449
11 Tax at 35% (1,400) (1,434) 828 3,550 5,778 3,902 1,586 507
12 Profit after tax (10-11) 2,600 (2,663) 1,537 6,595 10,731 7,246 2,946 942
 6-18

Example: IM&C’s Guano Project

Initial cash flow analysis
NCF = Cash flow from capital investment + disposal
+ Cash flow from changes in WC
+ Operating cash flow (OCF)

OCF = revenues – cash expenses - taxes

WC = inventory + accounts receivable – accounts payable

WC = Increase in inventory
+ Increase in accounts receivable
- Increase in accounts payable
 6-19

Example: IM&C’s Guano Project

Initial cash flow analysis
 6-20

Example: IM&C’s Guano Project

Notes on Investments in working capital:
1. Sales recorded on the income statement overstate actual cash
receipts because sales are increasing and customers are slow to
pay their bills. Therefore, accounts receivable increase.
2. as projected sales increase, larger inventories have to be held
in the aging sheds.
3. An offsetting effect occurs if payments for materials and
services used in guano production are delayed. In this case
accounts payable will increase.
 6-21

IM&C’s Guano Project

Details of cash flow forecast in year 3 ($1000s)

1. If you replace each year’s sales with that year’s cash payments
received from customers, you don’t have to worry about accounts
receivable.
2. If you replace cost of goods sold with cash payments for labor,
materials, and other costs of production, you don’t have to keep track of
inventory or accounts payable.
However, you would still have to construct a projected income statement
to estimate taxes.
 6-22

IM&C’s Guano Project

Impact of depreciation method
Tax depreciation allowed under the modified accelerated cost recovery
system (MACRS) (Figures in percent of depreciable investment)
Tax Depreciation Schedules by Recovery-Period Class
Year(s) 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
1 33.33 20 14.29 10 5 3.75
2 44.45 32 24.49 18 9.5 7.22
3 14.81 19.2 17.49 14.4 8.55 6.68
4 7.41 11.52 12.49 11.52 7.7 6.18
5 11.52 8.93 9.22 6.93 5.71
6 5.76 8.92 7.37 6.23 5.28
7 8.93 6.55 5.9 4.89
8 4.45 6.55 5.9 4.52
9 6.56 5.9 4.46
10 6.55 5.9 4.46
11 3.29 5.9 4.46
12 5.9 4.46
13 5.91 4.46
14 5.9 4.46
15 5.91 4.46
16 2.99 4.46
17-20 4.46
21 2.23
 6-23

IM&C’s Guano Project

Impact of depreciation method
Tax Payments when accelerated depreciation (MACRS)
n: 5 years
Period
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 Tax depreciation 2,000 3,200 1,920 1,152 1,152 576
5 Pretax profit (1-2-3-4) (4,000) (4,514) 748 9,807 16,940 11,579 5,539 1,949
6 Taxes at 35% (1,400) (1,580) 262 3,432 5,929 4,053 1,939 682

NPV (tax shields) = $2,174,000, about $331,000 higher

than under the straight-line method
 6-24

IM&C’s Guano Project

Revised cash flow analysis ($1000s)
 6-25

6.3 Using the NPV Rule to choose among projects

1. Problem 1: The investment Timing Decision

2. The choice between long- and short-lived
equipment
3. Problem 3: When to replace an old Machine
4. Problem 4: Cost of excess Capacity
 6-26

1. Problem 1: The investment Timing Decision

When Sometimes you have the ability to

defer an investment and select a time that is
more ideal at which to make the investment
decision.
A common example involves a tree farm.
You may defer the harvesting of trees. By
doing so, you defer the receipt of the cash
flow, yet increase the cash flow.
 6-27

1. Problem 1: The investment Timing Decision

 First step: Forecast net present value of the
harvest at different future date.
 Second step: Discount the net future value
back to the present.
 Finally, The optimal point of time to harvest =
the point that maximizes NPV.
Another way:
 compare the growth rate in the future net
present value (g)
 The optimal point = the point where g nearly
becomes less than cost of capital
 6-28

1. Problem 1: The investment Timing Decision

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?

Answer: Year 4
 6-29

1. Problem 1: The investment Timing Decision

Another Example
You may purchase a computer anytime within the
next five years. While the computer will save your
company money, the cost of computers continues
to decline. If your cost of capital is 10% and
given the data listed below, when should you
purchase the computer?
 6-30

1. Problem 1: The investment Timing Decision

Another Example
You may purchase a computer anytime within the next five years. While
the computer will save your company money, the cost of computers
continues to decline. If your cost of capital is 10% and given the data
listed below, when should you purchase the computer?

Year Cost PV Savings NPV at Purchase NPV Today

0 50 70 20 20.0
1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 Date to purchase 25.5
4 33 70 37 25.3
5 31 70 39 24.2
 6-31
2. The choice between long- and short-lived equipment

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 annuity =
annuity factor
 6-32

Equivalent Annual Cash Flows

Example
Given the following cash flows from operating two
machines and a 6% cost of capital, which machine
has the higher value using equivalent annual annuity
method.(ignore tax – deduction from operating cost,
depreciation, ignore inflation)
Costs/Year
Mach. 0 1 2 3 PV@6% E.A.A.
A +15 +5 +5 +5 28.37 10.61
B +10 +6 +6 21.00 11.45
 6-33

Equivalent Annual Cash Flows

Another Example
Select one of the two following projects, based on
highest “equivalent annual cash flow” (r=9%).

Project C0 C1 C2 C3 C4 NPV EAA

C  15 4.9 5.2 5.9 6.2 2.82 .87
D  20 8.1 8.7 10.4 2.78 1.10
 6-34

1. Problem 3: When to replace an old Machine

2. Problem 4: Cost of excess Capacity
 6-35

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