CC5001 Examples and Exercises Week 4 Net Present Value The apparent costs of a project may appear different

when the future value of money is considered; Discounted Cash Flow (DCF) is one technique which allows us to see future costs in today's terms, i.e. the Net Present Value (NPV). Example Consider the following proposal: "If Amy lends Brian 1500 this year, Brian will repay Amy 500 next year, the year after, and the year after that." What is this worth? The apparent value is that 1500 is the same as three times 500, but this does not take account of the changing values over time. We can also see that Brian is not paying Amy any interest over this period. A closer examination reveals that there is a difference between the values of the sums involved. Consider this from Amys point of view, and also see what this means for Brian. Year DCF 10% DCF 12% 0 1.00 1.00 1 0.91 0.89 2 0.83 0.80 3 0.75 0.71 4 0.68 0.64

Net Present Value

Note that the value in Year 0 is 1.0 (or 100%), because the value in todays money is in full at the present day. We start in Year 0 we do not reach Year 1 until the following year (think of birthdays you are 1 year old on the first anniversary of your birthday). The proposed loan from Amys point of view Amy needs to consider whether the proposed loan arrangement is worthwhile. The following calculations, using the recommended DCF values, show that the proposed loan to Brian does not represent a good use of Amys money.
Value at 10% DCF Value at 12% DCF -1500 445 400 355 -300 Appare nt value Amys outlay Amys income

DCF 10%

Year 0 1 2 3 Total

-1500 500 500 500 1500

-1500

-1500 500 500 500 0

1.00 0.91 0.83 0.75

-1500 455 415 375 -255

1.00 0.89 0.80 0.71

Here, the loan results in a loss for Amy. At a DCF of 10% the NPV is -255, a loss in real terms. At a DCF of 12% the NPV is -300 in real terms, an even greater loss. It is important to note that we cannot choose a DCF value for the transaction; it would be wrong for Amy to tell Brian that she would agree to the loan at a lower DCF value. The DCF values employed are intended to reflect the financial environment; different DCF calculations are made to test the sensitivity of the proposals to changes in the financial environment. It would be possible to change the DCF values over the period, if this reflects what financial experts predict. For example, the recommended DCF for the first two years could be 8%, growing to 10% over the next two years. Predictions are plagued by uncertainty, which makes calculations further into the future less reliable than short-term estimates.

DCF 12%

CC5001 Examples and Exercises Week 4 The proposed loan from Brians point of view We can now examine how the load appears to Brian. As Brian receives 1500 now, and repays Amys loan without interest over the years ahead, he gains from the loan.
Value at 10% DCF Value at 12% DCF 1500 -445 -400 -355 300 Appare nt value Brians outlay Brians income

DCF 10%

Year 0 1 2 3 Total

1500

1500

0 -500 -500 -500 -1500

-1500 500 500 500 0

1.00 0.91 0.83 0.75

1500 -455 -415 -375 255

1.00 0.89 0.80 0.71

Here we can see that Amys loss is Brians gain. The DCF value of 10% leaves Brian 255 better off; and at a DCF value of 12% Brians gain rises to 300. It is usual in dealing with financial transactions to show the income as positive, and the outlay as negative. We can see here that the numeric values are exactly the same for Brian as they were for Amy, except that they are positive for Brian where they were negative for Amy, and vice versa. Here, the negative values have been indicated with a minus sign, but other notations use parentheses to indicate a negative number. Task 4.1 Amy tells Brian that the original loan proposal is not acceptable because of the loss she would make. Consider the following proposal: "If Amy lends Brian 1500 next year, Brian will repay Amy 500 this year, next year and the year after." Is this a better option of Amy? Use the same DCF values of 10% and 12%. Year DCF 10% DCF 12% 0 1.00 1.00 1 0.91 0.89 2 0.83 0.80 3 0.75 0.71 4 0.68 0.64

DCF 12%

Task 4.1

Check it out Burke R (1999) Project Management: Planning and Control Techniques. Wiley, Chichester: pages 56 - 58. Cadle J & Yeates D (2001) Project Management for Information Systems, 3rd Edition, Prentice-Hall, Harlow: pages 90 91. Gray CF & Larson EW (2000) Project Management: The Managerial Process, McGraw-Hill: pages 36 37. Lockyer K & Gordon J (1996) Project Management and Project Network Techniques, 6th edition, Prentice-Hall, Harlow: pages 7593. Maylor H (2003) Project Management, 3rd edition, Pearson Education, Harlow: pages 183 188. Meredith JR & Mantel Jr. SJ (2006) Project Management: A Managerial Approach, John Wiley & Sons, Asia: pages 5253, 6775.

Check it out

CC5001 Examples and Exercises Week 4

Example Bumblefist and Dogsbody are a company specialising in the office of office stationery. They have 10 clerks who generate invoices and letters, many of which are in a standard format. These clerks have PCs running WordPerfect; these are now out-of-date compared to PCs with more modern software packages. Management intends to replace these old PCs with news ones for word processing, setting up a customer database system, and using a spreadsheet for accounting information. The company has two options under consideration: (a) to purchase 10 personal computers together with software for 1000 each from Grabbit Computers (b) to rent 10 personal computers with software included at 1700 per annum for all 10 machines from Steadfast Equipment Supplies. If the rental option is pursued then maintenance, again for all machines, is 12 per annum for the first five years, then 15 per annum for the next five years, and 17.50 for the following five years. If Bumblefist and Dogsbody elect to purchase, maintenance is included in the purchase agreement for the first five years, after which the terms are 15 per annum for the next five years and 17.50 for the following five years, as with the rental agreement. Whether renting or purchasing, Bumblefist and Dogsbody will need to pay 10% of the initial purchase price every year in insurance. Bumblefist and Dogsbody expect that they will replace all the machines in 10 years, by which time they consider that they will have become worthless. In order to consider the best option for the company, Net Present Value calculations will need to be made in order to compare options (a) and (b). Discounted Cash Flow factors of (i) 11%, and (ii) 15% are used in order to assess the impact of the two proposals. The calculations will show which option appears to be better value in today's terms. Read the question carefully in order to calculate the rental and purchase values each year. Note in particular that the insurance is calculated as 10% of the purchase price; do not make the mistake of using 10% of the cost of rental. The DCF values are as follows:
Year/ DCF 11% 15% 0 1.00 1.00 1 0.90 0.87 2 0.81 0.76 3 0.73 0.66 4 0.66 0.57 5 0.59 0.50 6 0.53 0.43 7 0.48 0.38 8 0.43 0.33 9 0.39 0.28

CC5001 Examples and Exercises Week 4 In this example, all the values are expenditure. For clarity of presentation, neither minus signs nor parentheses have been used, but it should be remembered that the values below are negative (i.e. money being spent), and we should aim to minimise expenditure.
Rent Year Purchase DCF 15% DCF 11%

Rate at 11%

Maintenance

Maintenance

Rate at 15%

Insurance

Insurance

Basic

Basic

Total

Total

Rent

Rent

Buy

0 1 2 3 4 5 6 7 8 9 Totals

1700 1700 1700 1700 1700 1700 1700 1700 1700 1700 1700 0

12 12 12 12 12 15 15 15 15 15 13 5

1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 0

2712 2712 2712 2712 2712 2715 2715 2715 2715 2715 27135

10000

1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 10000

11000 1000 1000 1000 1000 1015 1015 1015 1015 1015 20075

1.00 .87 .76 .66 .57 .50 .43 .38 .33 .28

2712 2359.44 2061.12 1789.92 1545.84 1357.50 1167.45 1031.70 895.95 760.20 15681.12

11000 870 760 660 570 507.50 436.45 385.70 334.95 284.20 15808.80

15 15 15 15 15

1.0 0 .90 .81 .73 .66 .59 .53 .48 .43 .39

2712 2440.80 2196.72 1979.76 1789.92 1601.85 1438.95 1303.20 1167.45 1058.85 17689.50

11000 900 810 730 660 598.85 537.95 487.20 436.45 395.85 16556.30

10000

On the basis of this information, a decision could go either way, but supporting reasons should include consideration of factors such as: reliability of the supplier availability of help desk support training costs likelihood of the equipment becoming obsolete before the end of the ten-year period loss of investment opportunities should purchase be chosen, inflation difficulty in maintaining the equipment near the end of its life Further information that could be included in the calculations: any savings that can be identified; these can be traded-off against the costs, and these savings can also be evaluated in today's terms if they are expected to occur in the future. Task 4.2 Consider the proposal: "Charlie will give Alice 100 each year for the next five years (starting next year), if Alice gives Charlie 500 this year". What is this proposal worth for Alice and Charlie? Use DCF factors of 10% and 12%. What difference does it make if Charlie repays Alice 120 each year?
Year DCF 10% DCF 12% 0 1.00 1.00 1 0.91 0.89 2 0.83 0.80 3 0.75 0.71 4 0.68 0.64 5 0.62 0.57

Buy

Task 4.2

CC5001 Examples and Exercises Week 4 Task 4.3 A disposable party hat manufacturer, Chuck Beret, is considering investing in a new range of personal computer workstations in order to streamline the ordering and hire and sale of their range of party hats, which include policemen's helmets, nurses' caps, bowler hats and top hats. The organisation is considering two options, one for rental, and one for purchase: option 1 to rent 8 personal computers, including software, etc, at 2250 per annum for all equipment from Hare and Hatter systems option 2 to purchase 8 personal computers, with software, etc, for 11000 for all the equipment from White Rabbit Computers. If the rental option is pursued, maintenance for all machines will need to be paid at 300 per annum; this does not apply if the purchase option is selected. Insurance will need to be paid, whether renting or purchasing, at 10% of the purchase price. Chuck Beret plan to replace the equipment after five years, with the expectation that the new equipment and software will have reached the end of its useful life. You are required to analyse the options, using the DCF factors of 11% and 15% from the table below, and make a recommendation as to which option should be selected. Identify all factors that you consider relevant to the decision. DCF Factors Year DCF 11% DCF 12% DCF 15% DCF 18% 0 1.0 1.0 1.0 1.0 1 .90 .89 .87 .85 2 .81 .80 .76 .72 3 .73 .71 .66 .61 4 .66 .64 .57 .52 5 .59 .57 .50 .44 6 .53 .51 .43 .37 7 .48 .45 .38 .31 8 .43 .40 .33 .27

Task 4.3

CC5001 Examples and Exercises Week 4 Task 4.4 A sports and leisure club, Shuttleworth and Rackett, maintain a database of club members who book gymnasium equipment, squash and tennis courts, as well as more unusual pastimes such as fencing, yoga and T'ai Chi. There is also the opportunity to book sessions with a personal trainer at 20 per hour, or 100 for a full day. Standard membership costs 200 per calendar year, with a discount of 25% for full-time students. Club members may use their own equipment, but also have the option of hiring equipment when a booking is made. In order to deal with club membership, accounts, booking facilities and hiring equipment, as well as maintenance of facilities and equipment, Shuttleworth and Rackett have decided to update their computer system. The club will scrap their existing computer system which is no longer of any value, but can be removed free of charge if either of the following two options is chosen, both offered by the same supplier, Computer Concepts. option 1 to rent 15 personal computers, including software, etc, for 275 per machine per annum for the first five years, 320 per machine per annum for the next five years, and 480 per machine per annum thereafter. The cost of maintenance will be 50 per machine per annum throughout. option 2 to purchase 15 personal computers, with software, etc, for 1750 per machine. Maintenance will be 360 per annum for all machines for the first five years, then 480 for the next five years. Whichever option is chosen, insurance will need to be paid at 15% of the purchase price. Shuttleworth and Rackett plan to replace the equipment after eight years, when the equipment will have reached the end of its useful life, and will therefore be considered worthless. You are required to analyse the options, using the DCF factors of 11% and 15% from the table below. Which would be the best option for Shuttleworth and Rackett? Identify all relevant factors.

Task 4.4

DCF Factors Year DCF 11% DCF 12% DCF 15% DCF 18% 0 1.0 1.0 1.0 1.0 1 .90 .89 .87 .85 2 .81 .80 .76 .72 3 .73 .71 .66 .61 4 .66 .64 .57 .52 5 .59 .57 .50 .44 6 .53 .51 .43 .37 7 .48 .45 .38 .31 8 .43 .40 .33 .27

CC5001 Examples and Exercises Week 4 Task 4.5 A small to medium sized enterprise (SME) formed by three chemistry graduates, Gray, Forks and Knight, have won an award for their new power-saving luminous paint, and now wish to extend their activities to the research and development of other luminous products. Gray, Forks and Knight have recruited new staff in order to support their research ideas, and they are now in a position to invest in new computer equipment. Two options are outlined below. option 1 to rent 15 computers, including software, etc, at an agreed annual rate per machine (320 for the first year, 355 for the next, 390 the following year, then 445 for the year after, and 510 for the final year). This increasing rate has been agreed as it includes maintenance at no additional charge. option 2 to purchase 15 computers, with software etc, for 1150 per machine, with an additional maintenance charge (in the year of purchase: 90 per machine. Charge per machine for each subsequent year: 100, 110, increasing at the rate of 10 per machine per year). The cost of insurance will be 8% of the purchase price, whether renting or purchasing. Gray, Forks and Knight plan to replace the equipment after five years, with the expectation that it will have reached the end of its useful life. As approval from the European Union is required, Gray, Forks and Knight need to provide an analysis of the options using the DCF factors of 11%, 12%, 15% and 18%, and they have asked you to undertake this activity. Use the factors from the table below, and make a recommendation as to whether option 1 or option 2 should be selected. Identify all factors that you consider relevant to the decision.

Task 4.5

DCF Factors Year DCF 11% DCF 12% DCF 15% DCF 18% 0 1.0 1.0 1.0 1.0 1 .90 .89 .87 .85 2 .81 .80 .76 .72 3 .73 .71 .66 .61 4 .66 .64 .57 .52 5 .59 .57 .50 .44 6 .53 .51 .43 .37 7 .48 .45 .38 .31 8 .43 .40 .33 .27

CC5001 Examples and Exercises Week 4 Task 4.6 A new company, Midclay and Barland, specialising in independent financial advice, are planning to set up a computer system to store details about their clients, as well as a web site with "frequently asked questions" (FAQs) to encourage potential customers. Midclay and Barland have narrowed the possibilities down to a choice of two (both proposed by Satisfactory Systems) which they are now evaluating. option 1 to rent 20 workstations at 400 per machine per annum (the rental increasing by 50 per machine each year). There is no additional fee for maintenance. option 2 to purchase 20 workstations for 1500 per machine, with an annual maintenance charge of 25 per machine starting in the year of purchase. There is no additional fee for insurance, which has been included in the basic cost of acquiring the office accommodation. Midclay and Barland have negotiated a deal that after four years Satisfactory Systems will collect the equipment and pay Midclay and Barland 500 per workstation, whether the equipment had been rented or purchased. Satisfactory Systems plan to use these old workstations for spare parts, and a new deal will then be arranged, as Midclay and Barland plan to replace the equipment at this time. As financial advisers, Midclay and Barland are keen to establish how the two options appear over the years ahead, given the variability in interest rates. You are asked to analyse the options, using the DCF factors of 11%, 12%, 15% and 18% from the table below. You will need to take into account the income from the collection of the workstations. DCF Factors Year DCF 11% DCF 12% DCF 15% DCF 18% 0 1.0 1.0 1.0 1.0 1 .90 .89 .87 .85 2 .81 .80 .76 .72 3 .73 .71 .66 .61 4 .66 .64 .57 .52 5 .59 .57 .50 .44 6 .53 .51 .43 .37 7 .48 .45 .38 .31 8 .43 .40 .33 .27

Task 4.6