Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Steven Golbeck
Northwestern University, Department of Industrial Engineering & Management Sciences

April 9 and 11, 2012

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Equivalent Uniform Annual Cashow

Equivalent Uniform Annual Cashow Consider a cash ow stream (x0 , x1 , , xn ), with present value P :
n

P =
j =0

xj (1 + r)j

Suppose we have an annuity with payments A distributed over the same time frame (n periods) with the same present value, P : A 1 1 r (1 + r)n
n

=P =
j =0

xj (1 + r)j

The Equivalent Uniform Annual Cashow (EUAC) A to the cash ow stream, (x0 , x1 , , xn ), is dened as: A=r 1 1 (1 + r)n
1 n j =0

xj 1 = rP 1 (1 + r)j (1 + r)n

This can be implemented in Excel as: A = PMT(r,n,-P)

Steven Golbeck Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Equivalent Uniform Annual Cashow

To calculate EUAC: (1) First calculate the present value of the cashow stream (2) Using Eq. 2, compute the EUAC. Example For example, in the case of an annuity with cash ow stream, x0 = 0 and xi = x for i = 1, 2, ..., n, we have that: A = r 1 1 (1 + r)n
1 n xj n j =0 (1+r )j

x
j =1 1

1 (1 + r)j

= =

1 r 1 (1 + r)n x

x 1 1 r (1 + r)n

So as expected, the EUAC for an annuity is just the annuity payment.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Equivalent Uniform Annual Cashow

Example What is the EUAC of the following cash ow stream xi = x, for i = 0, 1, .., n 1, and xn = x + B ? First compute the PV of the cash ow stream:
n

=
i=0

x B xi =x+ + i (1 + r)i (1 + r ) (1 + r)n i=1 x 1 1 r (1 + r)n + B (1 + r)n

x+

Next determine the payments, A, of an annuity with n end-of-period payments that has the same present value, P , that we found above: EU AC = = r x+ x 1 1 r (1 + r)n B (1 + r)n + B (1 + r)n 1 (1 + r)n 1
1

1 (1 + r)n

x+r x+

So for the EUAC we get the original periodic payment x, plus extra due to the lump sum at the end, B , plus the upfront payment, x.
Steven Golbeck Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Equivalent Uniform Annual Cashow

Example A purchasing agent plans to buy some new equipment for the mailroom. Two companies have provided bids, which are summarized in the table. Company Speedy Allied Cost 1500 1600 Useful Life 6 12 Salvage Value 200 325

Assume 7% interest and equal maintenance costs. Compute the EUAC for each product.

Speedy PV = = Aspeedy = = 1500 + 200/(1 + r)6 $1366.73 1 r 1 (1 + r)6 $286.74

1

Allied PV = = PV Aallied = =
Steven Golbeck

1600 + 325/(1 + r)12 $1455.7 r 1 1 (1 + r)12 $183.28

1

PV

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Example Company Speedy Allied Cost 1500 1600 Useful Life 6 12 Salvage Value 200 325

Note that Allied has twice the useful life as Speedy. Shouldnt we compare them over the same period? Lets consider the case where after 6 years, we salvage the Speedy product, and purchase another (assume prices are stable), which we use for the next 6 years and salvage at the end of year 12. What is the EUAC for this case? PV = = 1500 + 200/(1 + r)6 + 1366.73 1 1500 + 200/(1 + r)6 (1 + r)6

1 (1366.73) = $2, 277.44 (1 + r)6

The EUAC is then: A = PMT(0.07,12,2277.44) = $286.73 Moral of the story: if the cash ows take the form of a cycle, then you only need to consider a single cycle to compute the EUAC. This suggests that EUAC is useful for comparing the cost of dierent projects that one anticipates repeating, but each of the alternatives has a dierent cycle length.
Steven Golbeck Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Expected NPV and Simulation

Uncertainty in Cashows A purchasing agent plans to buy some new equipment for the mail room. Two manufacturers have provided bids, which are summarized in the table. Assume 7% interest and equal maintenance costs. Which manufacturer should you purchase from? Manufacturer Speedy Allied Cost 1500 1600 Useful Life (yrs) 5 5 Salvage Value 200 400

We would nd that Allied has a lower Equivalent Uniform Annual Cost (EUAC), 320.67 versus 331.06, and so we would purchase from them. What if we are uncertain about the salvage value of the equipment from Allied?

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

We decide that we must consider three scenarios: Case 1: (optimistic) salvage value is 600 Case 2: (most likely) salvage value is 400 Case 3: (pessimistic) salvage value is 50 Should this inuence our decision? Lets compute the NPV in each scenario: N P V1 N P V2 N P V3 = = = 1600 + 600/(1 + r)5 = 1172.21 1600 + 400/(1 + r)5 = 1314.81 1600 + 50/(1 + r)5 = 1564.35

To compute the EUAC, multiply the NPVs by the annuitization factor: r 1

1 (1+r )n 1

= PMT(0.07,5,-1) = 0.24389
1

EU AC1 EU AC2 EU AC3

= = =

r 1 r 1 r 1

1 (1 + r)n 1 (1 + r)n 1 (1 + r)n

N P V1 = 1172.21(0.24389) = 285.89
1

N P V2 = 1314.81(0.24389) = 320.67
1

N P V3 = 1564.35(0.24389) = 381.53
Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Steven Golbeck

EU AC1 EU AC2 EU AC3

= = =

r 1 r 1 r 1

1 (1 + r)n 1 (1 + r)n 1 (1 + r)n

N P V1 = 1172.21(0.24389) = 285.89
1

N P V2 = 1314.81(0.24389) = 320.67
1

N P V3 = 1564.35(0.24389) = 381.53

What we see is that in the third, pessimistic, scenario, purchasing from Speedy would have been less costly. In order to build a framework for accounting for these scenarios, we need some tools from probability theory. If you have not had a course in probability theory, or want a more lengthy refresher: http://users.iems.northwestern.edu/~sgolbeck/mmmreview_v2_1.pdf

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Quick Review of Probability

Let Ai , i = 1, 2, .., n, be mutually exclusive outcomes of a random experiment. If these events cover the entire sample space, meaning all possible outcomes, then we have that:
n

P (Ai ) = P (A1 ) + P (A2 ) + P (An ) = 1

i=1

Example You roll a die with the outcome being a number from 1 to 6. If the die is fair, then P ({i}) = 1/6 for i = 1, 2, ..., 6.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Quick Review of Probability

Independence Suppose A and B are independent events. This means that knowing whether or not A occurs does not eect the probability of B occurring, and vice versa. Then the probability of A and B occurring is: P (A B ) = P (A)P (B ) Examples Suppose you roll one die, record the outcome as i, then roll a second die and record its outcome as j . Assuming both dice are fair, and the rolls are independent, the probability of any combination is: P ({i} {j }) = P ({i})P ({j }) = 1/36

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Quick Review of Probability

Random Variables DEFINITION: A random variable X is a function that takes as inputs outcomes or events of a random experiment, and returns a number. Example: let X record the outcome of a roll of a die, and Y record the square of the outcome of a roll of a die. Both X and Y are random variables. We denote by lower case letters, the values they take, e.g. x and y

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Quick Review of Probability

Expected Value When the outcomes of an experiment are countable and nite, the expected value of a random variable X is given by:

E[X ] =

xi P ( A i )
i=1

where Ai are the events or outcomes of the random experiment and xi are the values X takes on associated with those events. Example The expected value of X in the die-rolling example is:

E[X ] =

6 i=1

i = 3.5 6

The expected value gives us an idea of what we would expect if we measured X in a large number of independent experiments and took the sample average.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Expected NPV Back to the equipment example, but now assign probabilities to each of the three scenarios: Case 1 2 3 Probability 0.2 0.5 0.3 Salvage Value 600 400 50

Now we think of the NPV as a random variable, which for each of the three outcomes, gives a dierent cost. Using the tools of probability, lets nd the expected NPV of purchasing the equipment from Allied:

E[N P VA ]

= = =

p1 N P V1 + p2 N P V2 + p3 N P V3 (0.20)(1172.21) + (0.50)(1314.81) + (0.30)(1564.35) 1361.15

In the case of Speedy, we have that N P V = 1357.40. If we base our purchasing decision on Expected NPV, we would purchase the equipment from Speedy.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Expected NPV WARNING: In general,

E[f (X )] = f (E[X ]), as this next example illustrates.

Case 1 2 Probability 0.6 0.4 Useful Lifetime 5 10

Now suppose that there is uncertainty about the useful lifetime of the Speedy equipment, and you assign the following probabilities to the two scenarios:

Note that the expected life is (0.6)5 + (0.4)10 = 7 years. The salvage value is still 200, and the upfront purchase price is 1500. If we were to compute the NPV using the expected life, we would obtain: N P V = 1500 + 200/(1 + r)7 = 1375.45 However, if we compute the expected NPV, we obtain:

E[N P V ] = (0.6)

1500 + 200/(1 + r)5 +(0.4) 1500 + 200/(1 + r)10 = 1373.77

Not a huge dierence in this particular case, but it can be pronounced if the distribution is heavily skewed. The main point is that the second approach is how you should compute expected NPV.
Steven Golbeck Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Midterm on Friday Bring a calculator and pen/pencil. Thats all you need. Formula Sheet will be provided (posted online). 4 questions, multiple parts. Covers up to and including Equivalent Uniform Annual Cost (EUAC). If you understand the homework and material in lectures, youll do ne.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

The examples we have considered so far involve a small set of scenarios, and thus computing the expected NPV is not terribly dicult. However, once the number of scenarios grows, or becomes uncountable, we must depend on techniques such as simulation. Example revisited Suppose that in the case of the Allied equipment, the useful lifetime n is distributed according to the discrete uniform distribution between 1 and 15 (15 possible values): p(n = i) = 1/15, i = 1, 2, ..., 15

and furthermore that the salvage value is distributed according to the Normal distribution with mean 500 and standard deviation 20: Y N (500, 202 ) We assume that the useful lifetime and salvage value are independently distributed. As before, the upfront cost is C = 1600. The expected NPV is then given by:

E[N P V ] = E

C+

Y (1 + r)n

This can be computed by hand, but theres no guarantee that this will always be true, so instead lets simulate it.
Steven Golbeck Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Simulation A simulation relies on the Law of Large Numbers, which states that if we consider a sample of independent and identically distributed (i.i.d.) random variables, Xi , i = 1, 2, ..., N , where [Xi ] = , then:

lim

1 N

Xi =
i=1

In a simulation, we generate a nite sample of the random variable X using random numbers, and estimate the expected value of X by taking the sample average: XN = 1 N
N

Xi =
i=1

X1 + X2 + + XN N

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Simulation In the cases we will consider, the random variable we wish to simulate may be a complicated function of several underlying random variables, such as above. Let f (X, Y ) be a random variable that depends on the value of two other random variables, X and Y . To simulate f (X, Y ), we rst generate N samples of X and Y , compute f (X, Y ) for each pair, then the nd the sample average: f (X, Y )N = 1 N
N

f (Xi , Yi )
i=1

To simulate the underlying random variables, we will rely on Excels RAND() function which returns a uniformly distributed random number between 0 and 1, and NORMINV which can be used to generate Normally distributed random variables.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Expected NPV and Simulation Suppose that in the case of the Allied equipment, the useful lifetime n is distributed according to the discrete uniform distribution between 1 and 15 (15 possible values): p(n = i) = 1/15, i = 1, 2, ..., 15

and furthermore that the salvage value is distributed according to the Normal distribution with mean 500 and standard deviation 20: Y N (500, 202 ) We assume that the useful lifetime and salvage value are independently distributed. As before, the upfront cost is C = 1600. The expected NPV is then given by:

E[N P V ] = E

C+

Y (1 + r)n

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Expected NPV and Simulation First consider the useful lifetime which takes a value in {1, 2, ..., 15}, each with the same probability. To generate a random variable from this distribution, we rst generate a uniform U (0, 1) random variable using RAND(), then compute: n = 1 + INT(15 RAND()) The INT function rounds down to integer values, so INT(15*RAND()) will return an integer in the range 0 to 14. To simulate the salvage value, we use RAND() to generate a value u = F (Y y ). Given this number, u, along with the mean and standard deviation of the Normal distribution N (, 2 ), the Excel function NORMINV(u,, ) returns the value y : y = NORMINV(RAND(), , )

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Expected NPV and Simulation Using these results we can generate N simulations of the NPV from the Allied equipment purchase: yi N P Vi = C + (1 + r)ni and take the sample average as an estimate of expected NPV. NP V = 1 N
N

N P Vi
i=1

Note that we can also simulate the EUAC, or any other random quantity of interest that is associated with the equipment purchase.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Consider a 20-year mortgage with a 7% interest rate and a 25% down payment. You can aord a $1500 monthly payment. How expensive of a house can you buy?

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Consider a 20-year mortgage with a 7% interest rate and a 25% down payment. You can aord a $1500 monthly payment. How expensive of a house can you buy? Find the present value of monthly payments, Q: Q= 1500 0.07/12 1 1 (1 + 0.07/12)240 = $193474

With a 25% down payment, Q is 75% of the price of the house, P : 0.75P = Q P = $257965 How large is the down payment?

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Consider a 20-year mortgage with a 7% interest rate and a 25% down payment. You can aord a $1500 monthly payment. How expensive of a house can you buy? Find the present value of monthly payments, Q: Q= 1500 0.07/12 1 1 (1 + 0.07/12)240 = $193474

With a 25% down payment, Q is 75% of the price of the house, P : 0.75P = Q P = $257965 How large is the down payment? The down payment D is 25% of the total cost of the house: D = 0.25P = $64491.30

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Bluth Industries just bought a new yacht. They estimate that the yacht will last for four years. The Bluths will pay $1000 in upkeep on the yacht next year, with maintenance increasing by $200 each year for each additional year of use. Instead, the Bluths can get a four service plan on the yacht, paid as a lump sum now. What is the most they should pay for the service plan? Assume a 15% interest rate.

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Bluth Industries just bought a new yacht. They estimate that the yacht will last for four years. The Bluths will pay $1000 in upkeep on the yacht next year, with maintenance increasing by $200 each year for each additional year of use. Instead, the Bluths can get a four service plan on the yacht, paid as a lump sum now. What is the most they should pay for the service plan? Assume a 15% interest rate. The most you would be willing to pay now is the net present value at time zero of the payments over four years. The maintenance costs are the cash ow stream (0, 1000, 1200, 1400, 1600). NP V = 1000 1200 1400 1600 + + + = $3612.27 (1.15) (1.15)2 (1.15)3 (1.15)4

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Hannah has owned a car for the last two years. When she bought the car, she took out a six year loan for $20,000 at an annual rate of 4% compounded monthly. Suppose that she has been making payments each month of $330. With this $330, she has been paying o all of the interest and a portion of the principal. How much principal is left on the loan now?

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Hannah has owned a car for the last two years. When she bought the car, she took out a six year loan for $20,000 at an annual rate of 4% compounded monthly. Suppose that she has been making payments each month of $330. With this $330, she has been paying o all of the interest and a portion of the principal. How much principal is left on the loan now? First, nd the NPV of payments,Q, over the rst two years at time zero: Q= 330 0.04/12 1 1 (1 + 0.04/12)24 = $7599.32

The present value at time zero of the principal left is the dierence between the total cost and the NPV of payments: 20000 7599.32 = $12400.68 Finally, move this value into the current time period (two years from time zero): 12400.68(1 + 0.04/12)24 = $13431.70

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Hannah has owned a car for the last two years. When she bought the car, she took out a six year loan for $20,000 at an annual rate of 4% compounded monthly. Suppose that she has been making payments each month of $330. With this $330, she has been paying o all of the interest and a portion of the principal. She is oered renancing now at 2% with a 3-year loan length. What is the minimum monthly loan payment if she takes this oer?

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Hannah has owned a car for the last two years. When she bought the car, she took out a six year loan for $20,000 at an annual rate of 4% compounded monthly. Suppose that she has been making payments each month of $330. With this $330, she has been paying o all of the interest and a portion of the principal. She is oered renancing now at 2% with a 3-year loan length. What is the minimum monthly loan payment if she takes this oer? If you take this loan, the minimum monthly payment you can make is the annual payment A that reduces the principal to zero after three more years, at an annual rate of 2%. Use the annuity NPV formula, rearranged with A on the left hand side: Pr 13431.70 0.02/12 A= = = $384.72 1 (1 + r)n 1 (1 + r)36

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

The University of South-Southeast New Hampshire is going to build a new football stadium. The stadium will cost $300 million to start building now. If the new stadium is built, next year the new stadium will become operational and the old stadium will be demolished at a cost of $2 million. Starting one year after it becomes operational, the new stadium will have $900,000 in maintenance done to it each year. In 2016 (it is now 2012) you will let the Goodwill Games use the stadium for some of their events. In exchange for letting you use the stadium, they will pay the maintenance costs in that year. The new stadium is expected to last for a very long time. Estimate the net present cost of building a new stadium if there is a 10% discount rate. The simplest way to estimate the value of the stadium, given that it will last for a very long time is to assume the $900,000 payments are forever. The universitys cash ow related to getting a new stadium, in millions, is (300, 2, 0.9, 0.9, 0, 0.9, 0.9, 0.9 . . . We can to use the perpetuity formula for the -0.9 payments that happen forever, so we can split this up into the sum of cash ows: (300, 2, 0, 0, 0.9, 0, 0, 0, . . .) + (0, 0, 0.9, 0.9, 0.9, . . . First, calculate the present cost of the rst stream: 300 + 2 0.9 (1 + r) (1 + r)4
Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV

Steven Golbeck

The University of South-Southeast New Hampshire is going to build a new football stadium. The stadium will cost $300 million to start building now. If the new stadium is built, next year the new stadium will become operational and the old stadium will be demolished at a cost of $2 million. Starting one year after it becomes operational, the new stadium will have $900,000 in maintenance done to it each year. In 2016 (it is now 2012) you will let the Goodwill Games use the stadium for some of their events. In exchange for letting you use the stadium, they will pay the maintenance costs in that year. The new stadium is expected to last for a very long time. Estimate the net present cost of building a new stadium if there is a 10% discount rate. Use the perpetuity formula for the second stream: 0 .9 r This is the present value at year one of the perpetuity, so we need to discount it to year zero, and add the two values together: 300 + 2 0.9 0.9 1 + = 309.39 million dollars 1+r (1 + r)4 r (1 + r)

Steven Golbeck

Lecture 7-8: Equivalent Uniform Annual Cashow & Expected NPV