Professional Documents
Culture Documents
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Overview
Traditional methods for project selection
DCF and the relevant project cash flows
Mutually exclusive investments Projects
with unequal economic life
A formula for the infinite replications NPV
Optimal investment timing with growth
The simple problem (without rotations)
Timing with replications (rotations)
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NPV
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Discounting Review
Ct
t
t 1 (1 K )
The present value is a sum of present
values.
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constant growth perpetuity
growth rate g:
i.e. Ct= (1+g) Ct-1
PV C /( K g )
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Annuity -
() (annuity)
(PV) =
1
C
t
K K 1 K
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NPV
NPV and a simple example
If the economic life of a project is 10 years, the investment
capital required is equal to 5000, the company is at a tax
bracket of 50%, is using a 10% discount rate for the cash
flows of the project, and uses straight line depreciation, what
is the NPV of the project?
We will use the pro forma income statement below to
estimate the cash flows.
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NPV
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NPV
The true cash flows to use are
Thus NPV =
PV(1000 for 10 years discounted at 10% p.a.) 5000 =
6144.57 5000 = 1144.57.
The project has a positive NPV and is thus accepted
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NPV
Another example
An investment to improve production efficiency requires
capital outlay 10000, it has an economic life of 5 years and
saves annually 3000 in salaries. Investment is financed with a
loan of 15% per year, the principal to be repaid (amortized)
by 10000/5 = 2000 per year. Taxes are at 40% and after tax
cost of capital is 20%.
What is the NPV? (the 5 year annuity factor is 2.991)
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NPV
Answer
Cash flows are: 3000(1-0.40)+0.40(2000)
=2600 per year.
Present value of cash flows: 2600(2.991)
= 7776.60
NPV = 7776.60 10000 = -2223.40
NOT ACCEPTABLE
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From the three methods above, only the third (the infinite
replications NPV) is always correct.
If the projects under comparison have the same risk (thus
they have the same relevant discount rate), then the first two
methods are correct too.
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Example
We have two mutually exclusive projects with different lives.
Their cash flows are:
Year
Project A
Project B
0
-10.00
-10.00
1
6.00
6.55
2
6.00
6.55
3
6.55
The opportunity cost of capital is 10% for A, but 40% for the
riskier project B. For each project we must calculate the
simple NPV, the NPV(N,), and the annual equivalent value.
Which project should be accepted and why?
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Example
The simple NPV first:
Year CF(A) PVIF(10%) PV
CF(B) PVIF(40%) PV
0
-10.00
1.000 -10.00 -10.00
1.000
-10.00
1
6.00
.909
5.45 6.55
.714
4.68
2
6.00
.826
4.96 6.55
.510
3.34
3
6.55
.364
2.39
------------.41
.41
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Example
The NPV(N,) for each project is:
NPV(N,) for A =
.4 1
1 .1 2
1 .1 2 1
. 4 1(1 . 2 1 / . 2 1) . 4 1( 5 . 7 6 1 9 ) 2 . 3 6
NPV(N,) for B =
. 4 1 1 1. 4. 43 1 . 4 1( 2 . 7 4 4 / 1 . 7 4 4 ) . 4 1(1 . 5 7 3 4 ) . 6 5
3
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Example
The concepts will be further demonstrated with an example.
At time t = 0 we invest capital cost I = 15000 in a tree lot. When
we harvest we get revenues Rev(t) = 10000sqrt(1+t). There is
an opportunity cost of capital K = 5% with continuous
discounting. In this example the expenses in order to harvest
are zero (constant in time and X = 0).
K = [dRev(t)/dt - dX(t)/dt]/(Rev(t) - X(t)), so
K = [dRev(t)/dt]/Rev(t).
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Example
K = [dRev(t)/dt]/Rev(t).
= [(0.5)10000/sqrt(1+t)]/[10000sqrt(1+t)]
= 1/[2(1+t)]
and since K = 0.05
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Example
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Example - discussion
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Visual Example
If for example we invest now, NPV equals 413.2231. If we
wait for a year, the capital cost I = 10475, and the yearly
revenues equal 6300 per year. The NPV one year later would
be equal to 458.8843, exhibiting a growth rate of 11.05%.
The present value of that investment today equals 417.1675.
Looking at the numerical results for timing of the investment
up to 10 years later, it is obvious that we maximize NPV if
we wait for about 4 years. At that time, the growth rate of
waiting equals 10.1234 that is close to the 10% cost of
capital.
The analytical calculations follow:
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Visual Example
Value at T
NPV
413.2231
413.2231
---------
458.8843
417.1675
0.1105
508.016
419.8479
0.107068
560.8482
421.3736
0.103997
617.625
421.8462
0.101234
678.6056
421.3607
0.098734
744.0648
420.0052
0.096461
814.2947
417.8619
0.094387
889.6048
415.0072
0.092485
970.3237
411.512
0.090736
10
1056.8
407.4421
0.089121
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Visual Example
Note that if there was a single growth rate (the same growth
rate for net revenues and the capital cost), if g > K we should
wait for ever (!!!), if g < K we must make the investment
immediately (should have been made already), and if g =
K we are indifferent about the timing.
These are of course not realistic examples, aggregate g for the
project value in general should not be constant. The visual
example instead is very realistic since .
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Max(t)[NPV(t) =
I+(Rev(t) X(t))e-Kt +(Rev(t) X(t))e-2Kt +(Rev(t) X(t))e-3Kt
= I+PV(t)]
where PV(t) equals the present value of the net revenues for all
rotations.
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Numerical Example
We use X(t) = X = 15000, K = 0.05 and
Rev(t) = 10000sqrt(1+t),
we use d[Rev(t) X(t)]/dt = [Rev(t) X(t)]K/(1 e-Kt)
we get
d[Rev(t) X(t)]/dt = d[Rev(t)]/dt = 10000d[sqrt(1+t)]/dt
= 10000(0.5)/[sqrt(1+t)]
and [Rev(t) X(t)]K/(1 e-Kt)
= [10000sqrt(1+t)-15000](0.05)/(1 e-0.05t)
which due to the non-linearity is solved by approximation
(numerically-with trial and error) to give (approximately)
t = 4.6. The NPV must also be calculated depending on I to
decide if the project is finally accepted or not.