SIMAD UNIVERSITY

MAKING INVESTMENT DECISIONS

WITH THE NET PRESENT VALUE
RULE
Learning objective

To estimate cash flows for a capital-budgeting project

To handle issues related to inflation

To solve realistic, complex capital-budgeting problems when the timing of alternatives vary

To employ equivalent annual cash-flow techniques

Evaluation techniques of project

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY

OVERVIEW
In this chapter, many practical aspects of capital budgeting are covered. From a practical point of view, this
is an extremely important chapter. Topics include cash flow estimation; depreciation; project evaluation in
other countries and currencies; projects with differing lives; equivalent annual cost; the decision to replace an
existing machine; and the cost of excess capacity. All these topics are of interest to financial planners. These
topics are of immense interest to project managers and engineers also.
Applying the net present value rule
Rule 1: Only Cash Flow Is Relevant, Record capital expenditures when they occur , To determine cash
flow from income, add back depreciation and subtract capital expenditure and Working Capital Difference
between companys short-term assets and liabilities
Rule 2. Cash flows should be estimated incrementally, the financial manager should look at the difference
in the firms cash flow with the project versus without it.
Rule 3: Treat Inflation consistently; nominal discount rates for nominal cash flows and real rates for real flows.
No mixing allowed!
Equivalent annual cash flows

Equivalent annual cash flows are examined whenever we have competing projects with different life spans.
This is the annual cash flow sufficient to recover a capital investment including the cost of capital, over the
economic life of the investment.
this method is useful for making the following types of decisions.

Choosing between long- and short-lived equipment

Deciding when to replace an existing machine

Equivalent annual cost and technological change

Evaluating the cost of excess capacity

Inflation
Project produces real cash flows of -$100 in year zero and then $35, $50, and $30 in three following years. Nominal
discount rate is 15% and inflation rate is 10%. What is NPV?

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY

Real discount rate

1+ nominal discount rate

1+ inflation rate

1 .15
1 .045
1 .10

ExampleNominal figures

Year
0
1
2
3

ExampleReal figures

Cash Flow
PV @ 15%
100
100
35 1.10 = 38.5 138.15.5 33.48
50 1.10 2 = 60.5 160.15.52 45.75
30 1.10 3 = 39.9

39.9
1.153

26.23
$5.5

Year CashFlow
0

100

35

50

30

PV@4.50%
100
35
1.045
50
1.0452
30
1.0453

= 33.49
= 45.79
= 26.29
= $5.50

Note

Nominal cash flows are discounted using an inflation rate of 10%. Nominal cash flows include inflation. Real
cash flows do not include inflation and should be discounted using real discount rates. The PV is the same as
above. Conclusion: You get the same answer as long as you treat inflation consistently.
Illustration project

BEST QUALITY Inc is considering an investment of $5 million in plant and machinery. This is expected
to produce sales of $2 million in year 1, $4 million in year 2, and $6 million in year 3. Subsequent sales
will increase at the expected inflation rate of 10 percent. The plant is expected to be scrapped after 6
years with a salvage value of $1 million. It is depreciated for tax purposes on a straight-line basis of $1
million per year.

Operating costs are expected to be 70 percent of the sales.

Working capital

requirements are negligible. GHI pays tax at 35 percent. Calculate the expected cash flows in each year
and the NPV of the investment when the required rate of return is 16 percent.
Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY
Years

1. Investment and salvage

6
6501

-5,000

2. Sales

2,000

4,000

6,000

6,600

7,260

7,986

3. Cost of goods sold

1,400

2,800

4,200

4,620

5,082

5,590

4. Depreciation

1,000

1,000

1,000

1,000

1,000

5. Pre-tax profit [2-3-4]

-400

200

800

980

1,178

2,396

6. Tax at 35% of 5

-140

70

280

343

412

839

7. Profit after tax [5-6]

-260

130

520

637

766

1,557

740

1,130

1,520

1,637

1,766

1,557

8. Operating cash flow [7+4]

9. Total cash flows [1+8]

-5,000

740

1,130

1,520

1,637

1,766

2,207

10. Present value at 16%

-5,000

638

840

974

904

841

906

11. Net present value

-5,000+638+840+974+841+906 = 103

Investment Timing Decision

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

Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make
the investment decision.
Example 1: 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, Assume an opportunity cost of capital of
10%.

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY
Year

Cost

Sales

0
1
2
3
4
5

Value

50
55
60
64
68
70

70
80
88
95
102
105

NPV
20
25
28
31
34
35

20
22.7
23.1
23.3
23.2
21.7

Net Present Value

N P V

C t
C1
C 2

.
.
.

(1 r ) 1
(1 r ) 2
(1 r ) t

Terminology
C0 Initial Cash Flow (often negative)
Cl Cash Flow at time 1
C2 Cash Flow at time 2
Ct Cash Flow at time t
t Time period of the investment
r Opportunity cost of capital
Net present value Example 2
Assume you plan to invest $1,000 today and will receive $600 each year for two years (assume the cash is received at
the end of the year). What is the net present value if there is a 10% opportunity cost of capital?
C0 = $1,000
C1 = $600
C2 = $600
r = 0.10

Solution
= $1000 +

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

. )

= $41.32

Ch 06 Making Investment

SIMAD UNIVERSITY

Choice between Long- and Short-Term Equipment

Equivalent annual cash flows are useful when comparing machines with different lives. In many cases you do not
need to consider the revenue side, as the machines would be producing the same output. This method has a number
of practical applications as managers and engineers routinely face these types of problems.

=
Example 3

1
(1 + ) )

Given the following cash flows from operating two machines and a 6% cost of capital, which machine has the higher
value using the equivalent annual annuity method?
Solution

t
Machine
A
B

0
15
10

year
1
2
5
5
6
6

3
5

PV@6%
28.37
21

E.A.A.
10.61
11.45

Therefore it is best to select machine A.

. In more robust examples, both positive and negative cash flows may occur. In both, the technique is useful.
When to Replace an Old Machine
In practice, the point at which equipment is replaced reflects economics, not physical collapse. We must decide when
to replace.
Example 4

A machine is expected to produce a net inflow of $4,000 this year and $4,000 next year before breaking. You
can replace it now with a machine that costs $15,000 and will produce an inflow of $8,000 per year for three
years. Should you replace now or wait a year? 6% cost of capital

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY
The cash flows of the new machine are equivalent to an annuity of $2,387 per year.
In practice, the point at which equipment is replaced reflects economics, not physical collapse. We must decide when
to replace.
Cost of Excess Capacity

Example

A computer system costs $500,000 to buy and operate at a discount rate of 6% and lasts five years
Equivalent annual cost of $118,700, Undertaking project in year 4 has a present value of 118,700/(1.06) 4, or about
$94,000
recognized, the NPV of the project may prove to be negative. If so, we still need to check whether it is worthwhile
undertaking the project now and abandoning it later, when the excess capacity of the present system disappears.

Evaluation Techniques
Payback period = Expected number of years required to recover a projects cost, If the projects payback
period is less than the maximum acceptable payback period Accept the project and is greater than, reject
the project

Management determines maximum acceptable payback period

NPV is the present value of an investment projects net cash flows minus the projects initial cash outflow.
Minimum Acceptance Criteria: Accept if NPV > 0 , Ranking Criteria: Choose the highest NPV
Profitability Index
Measures the benefit per unit cost, based on the time value of money
A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value ,
Can be very useful in situations of capital rationing , Decision Rule: If PI > 1.0 Accept

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY
Example

Initial investment in equipment

Annual cash increase in
operations:
Year 1
Year 2
Year 3

Proposal A
$90,000

Proposal B
$90,000

Proposal C
$90,000

80,000
10,000
45,000

45,000
45,000
45,000

90,000
0
0

Instruction

1. Find NPV each project

2. Find the Payback period
3. Find Profitability Index
4.

Rank each proposal 1, 2, and 3 using each method separately. Which proposal is best? Why?

Answer
Formula

CFt
CF0 .
t
t 1 1 r

NPV

NPV Initial cost 1.

Proposal A: Net present value $ 18,225 , Proposal B: Net present value $ 14,445 , Proposal C:
present value $ 11,070
2. Proposal A: 2 years , proposal B: 2 years , proposal C: 1 year

Net

Profitability Index = NPV/Investment

= .

= .

= .

Answer 4. Even though Proposal C is Number 1 for payback, it comes in last with the other two methods.
Because the net present value method takes into account the time value of money and the other proposals are
less comprehensive, Proposal A would be the best alternative.

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY

Problems
Problem one

Hormuud Inc. is considering a new project which requires an investment of $4 million. The project is
expected to generate sales revenue of $1 million in the first year, $2 million in the second year and $3 million
for years 3, 4, and 5. The cost of goods sold is expected to be 75 percent of sales revenue. Other costs are
expected to be 7 percent of sales in the first year and 5 percent of sales thereafter. The project will need
working capital investment of $200,000 in the first year and an additional $100,000 in the second year. The
investment in plant ($4 million) will be depreciated using the MACRS schedule for the 5 year class. If the
companys opportunity cost of capital is 10 percent, calculate the NPV for the project. Assume that the plant
will operate for 6 years, and at the end of 6 years, the plant can be sold for a salvage value of $300,000. The
tax rate for the company is 36 percent
Problem two
Capital Cakes is considering replacing their oven with a new one. They have received two offers. Oven A has an
initial cost of $34,000, annual operating costs of $6,000, and an operating life of 4 years. Oven B has an initial cost of
$24,000, annual operating costs of $8,000, and operating life of 3 years. Which oven is the better choice? Assume an
opportunity cost of capital of 12 percent.

Problem three
Cash Flows
Project
Machine 1
Machine 2

C0
C1
C2
($3,000) ($800)
($800)
($2,000) ($1,300) ($1,300)

C3
($800)

Given the following costs of operating two machines and an 8% cost of capital, Find equivalent annual
annuity method ? Select the lower-cost machine
Problem four
Ahmed a cellar of wines from his aunt, The local wine dealer offered Joe $70,000 for all the entire
collection. A sommelier (wine expert) friend of Ahmed suggested that if he kept the wines for another
five years he could sell them for $150,000. If Ahmed s opportunity cost is 14 percent, what is the best
course of action for Ahmed?
Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

SIMAD UNIVERSITY

Problem five
Hormuud Corp. is evaluating an investment project which will cost $40 million and generate taxable
revenues of $11 million per year for 7 years. There will be no salvage value at the end of this period.
Hormuud is currently unsure whether the investment will belong to the 3-year, 5-year, or 7-year recovery
period class. Calculate the NPV of the project for each of these three possibilities. hormuuds tax rate is 35
percent and its required return is 15 percent.
Problem six
An investment of $200,000 in a computer is expected to reduce costs by $40,000 a year in perpetuity.
However, the prices of computers are predicted to fall at 10 percent a year for the next 5 years. When should
the computer be purchased if the cost of capital is 13 percent?
Problem seven
The Top Company must choose between machines A and B, which perform exactly the same operations but
have different lives of 2 and 3 years, respectively. Machine A costs $30,000 initially and has annual costs of
$5,000. Machine B has an initial cost of $40,000 and annual costs of $7,000. If Bluebirds cost of capital is
10 percent, which machine should it choose?
Problem eight
A machine costs $100,000. At the end of the first year, $5,000 must be spent on maintenance. Each year, the
cost of maintenance rises by 15 percent. How long should the machine be kept before it is scrapped if the
opportunity cost of capital is 10 percent? (Assume the machine has a zero salvage value.)
Problem nine
Year

Maintenance
Cost

Salvage
Value

$2,000

$2,500

$3,000

$2,000

$4,000

$1,500

$5,000

$1,000

$5,000

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

10

SIMAD UNIVERSITY
XYZ Company is considering whether to replace an existing machine or to spend money on overhauling it.
The replacement machine would cost $18,000 and would require maintenance of $1,500 at the end of every
year. At the end of l0 years, it would have a scrap value of $2,000 and would not be maintained. The
existing machine requires increasing amounts of maintenance each year, and its salvage value is falling as
shown below:

If XYZ faces an opportunity cost of capital of 15 percent, when should it replace the machine?
Problem ten
The acceptance of a particular capital budgeting proposal will mean that a new computer costing $200,000
will be purchased in 1 year's time instead of in 3 years' time. This also implies that an extra computer
programmer costing $30,000 a year must be hired in year 1 instead of year 3. Work out the present-value
cost of these two items when the opportunity cost of capital is 14 percent.

Problem Eleven
Bayerhouser Timber has vast tracts of timber land. One tract in the northwest region has timber ready for
harvest and at current market prices will fetch a net revenue of $12 million. If the company waited for 1
year, 2 years, 3 years, and 4 years, the values would be $15 million, $17 million, $18 million, and $19
million respectively. What is the optimal harvesting point for the company if the cost of capital is 15
percent?

Lecturer Yusuf H. Mohamed

Sub: Corporate finance

Ch 06 Making Investment

11