Chapter 8 Part 1

Chapter 8 Net present value
Capital means money
Budgeting means a plan
Capital budgeting is the process of planning for major investments in a business These are usually larger projects, for example: Building a new factory Replacing old equipment Starting a new product line
The big picture

Is it worth it?
For example:
Should your company spend $1 million today to open a new factory? The answer depends on how much money the new factory will make for the company
This usually requires estimates of what will happen in the future
Examples
Movies Apple iPod Boeing 777 Smaller projects
Software upgrades Equipment replacement/upgrade New product introduction Etc., etc.
Movies are a good example

They often require large investments to make the movie
How much money the movie will make is uncertain
Suppose you are an executive at GDL Studios.

You have to decide on a proposal to spend $100 million on a new movie How would you decide?
After extensive research, you expect the movie to make the following profits, in millions of dollars
Year 1 $75 Year 2 $15 Year 3 $20 Year 4 $4 Year 5 $1
Is this worth a $100 million investment? $75 + $15 + $20 +$4 + $1 = $115 This is not a valid argument because: (1) It does not account for the time is takes to earn the profits (2) It does not consider the return investors require
Decisions
We use several techniques in finance to make capital budgeting decisions The best one is Net Present Value
NPV = Present value of future cash flows cost today
Movie example
The movie requires a $100 million investment today
It will generate the following profits in the future:
Is it worth it? Suppose investors require a 10% return.
$75 $15 = + 1 + 10% 1 + 10%
2+
$20 1 + 10%
3+
$4 1 + 10%
4+
$1 1 + 10%
PV future cash flows = $98.96 million
If
NPV > 0
NPV < 0
Movie Example PV of future cash flows Cost to make the movie NPV $98.96 million $100 million -$1.04
Suppose Ryan Gosling reads the screenplay, and expresses interest in starring in our movie Could this change our decision?
We estimate that with Ryan Gosling in the movie, the cash flows will be:
Assuming the same $100 million budget, does this change our decision?
$95 $20 = + 1 + 10% 1 + 10% $25 2 + 1 + 10% $4 3 + 1 + 10% $1 4 + 1 + 10%
5
PV future cash flows = $125.03 million If Ryan has the same information that we do, how much will his agent ask for as his payment?
Example 8.1, page 231: New computer

Cost: $50,000 Will last for 4 years Reduce costs by $22,000 per year Required return = 10%
Is it worth it?
N 4
I 10
PV ? $69,737
PMT 22,000
FV 0
NPV = $69,737-$50,00=+$19,737
Which should you choose?
Using NPV to choose among projects Your studio has two movie proposals for next summer: The discount rate is 10%
Movie 1 Action, budget is $100 million
Year1 $85 Year2 $25 Year3 $10 Year4 $2
Movie 2 Romance, budget is $60 million

Find the NPV of Movie 1 A. -1.82 B. 3.25 C. 6.81 D. 9.19
Year1 $85 CF01 Year2 $25 CF02 Year3 $10 CF03
2+
Year4 $2 CF04
$85 $25 + 1 + 10% 1 + 10%
$10 1 + 10%
3+
$2 1 + 10%
PV = $106.81, NPV = $106.81 - $100 = $6.81
Year1 $55 Year2 $20 $5 Year3 Year4 $1
Find the NPV of Movie 1 A. 4.25 B. 7.39 C. 8.41 D. 10.97
Year1 $55 CF01 Year2 $20 CF02 NPV = 10.97 $5 CF03 Year3 Year4 $1 CF04
Net present value

Movie 1
$85 $25 = + 1 + 10% 1 + 10% $10 + 2 1 + 10% $2 + 3 1 + 10%
4
PV = $106.81, NPV = $106.81 - $100 = $6.81
Movie 2
$55 $20 = + 1 + 10% 1 + 10% $5 2 + 1 + 10% $1 3 + 1 + 10%
4
PV = $70.97, NPV = $70.97 - $60 = $10.97
Net present value

Movie 1
NPV = $6.81 Which one should you choose?
Movie 2
NPV = $10.97
Since both NPVs > 0, make both movies if you can. If the studio budget < $160 million, then make Movie 2, because it has a higher present value
Your company is considering buying out a competitor. It will cost $475,000 to buy the competitor. You estimate that this will improve cash flows to your company as follows:
Year 1 2 3 4 5 Net cash flow $125,000 $175,000 $113,000 $75,000 $42,000
The discount rate is 14%. Q1: What is the PV of the future cash flows? A. $136,088 B. $288,203 C. $386,797 D. $422,118
Year 1 Net cash flow $125,000 CF Button CF01
2
3 4 5
$175,000
$113,000 $75,000 $42,000
CF02
CF03 CF04 CF05
The discount rate is 14%. Q1: What is the PV of the future cash flows? PV = $386,797
Year Net cash flow CF Button PV = $386,797
1 2
3 4 5
$125,000 $175,000
$113,000 $75,000 $42,000
CF01 CF02
CF03 CF04 CF05
The discount rate is 14%. What is the NPV of the project?
A. B. C. D.
-$136,088 -$ 88,203 $ 44,192 $109,385
You are considering investing in rental property. The property costs $365,000. You estimate that you can make $50,000 per year in rental income (after expenses). You plan to keep the property for 8 years, and you think you can sell the property for about $550,000 8 years from now. If the discount rate is 9%, what is the NPV of this project?
A. -$144,874 B. -$ 26,649 C. $ 76,686 D. $187,767
You are considering investing in rental property. The property costs $365,000. You estimate that you can make $50,000 per year in rental income (after expenses). You plan to keep the property for 8 years, and you think you can sell the property for about $550,000 8 years from now. If the discount rate is 9%, what is the NPV of this project?
A. -$144,874 B. -$ 26,649 C. $ 76,686 D. $187,767 N 8 I 9 PV ? 552,767 = 552,767 365,000 = 187,767 PMT 50,000 FV 550,000
Year 0 1 2
Project A -200 80 80
Project B -200 100 100
3 4
The discount rate is 11%. What is the NPV of project A?
80 80
100 0
A. -12.18 B. - 4.92 C. 25.14 D. 48.20
Year 0 1 2
Project B -200 100 100

PV=248.20
3 4
The discount rate is 11%. What is the NPV of project A?
80 80
100 0
= 248.20 200 = 48.20 A. -12.18 B. - 4.92 C. 25.14 D. 48.20
Year 0 1 2
Project B -200 100 100
3 4
The discount rate is 11%. What is the NPV of project B?
80 80
100 0
A. B. C. D.
23.22 37.88 44.37 51.53
Year 0 1 2
Project B -200 100 100
3 4
The discount rate is 11%. What is the NPV of project B?
80 80
100 0
PV=244.37
= 244.37 200 = 44.37 A. B. C. D. 23.22 37.88 44.37 51.53
Year 0 1 2
Project B -200 100 100
3 4
The discount rate is 11%.
80 80
= 48.20
100 0
= 44.37
Which project is worth pursuing? A. B. C. D. Project A Project B This is a trick question Ask the goddess
Year 0 1 2
Project B -200 100 100
3 4
The discount rate is 11%.
80 80
= 48.20
100 0
= 44.37
Which project is worth pursuing? Since both have a positive NPV, both are worth doing. A. B. C. D. Project A Project B This is a trick question Ask the goddess
Payback period How many years until I get the cost of the investment back? Example:
A machine costs $10,000 per year to operate I can replace it with a new machine that will only cost $5,000 per year to operate
The new machine costs $15,000
What is the payback period for the new machine?

3 years
Problems with the payback method:

Ignores cash flows that occur after the payback period
Example: Your company only accepts projects with a payback period < 3 years. You have a project that costs $50,000 and will provide the following cash flows:
Year 1 $10,000 Year 2 $10,000 Year 3 $10,000 Year 4 $10,000 Year 5 $1,000,0000
The payback > 3, but the NPV is >>0.
Other problems with the payback method:

Ignores the time value of money Leads the firm to accept short term project and ignore long-term projects of value
The payback period is still often used

As a rule of thumb Because it is easy to explain and understand
Perhaps because quick paybacks lead to quick promotions
Problem #1 Year 1 2 3 4 5 Cash flow $9,000 $9,000 $9,000 $9,000 $9,000
This project will require an initial investment of $35,000. If the discount rate is 12%, what is the projects NPV? a. b. c. d. -$10,000 -$ 2,557 +$ 2,557 +$10,000
Year 1 2 3 4 5
Cash flow $9,000 $9,000 $9,000 $9,000 $9,000 PV=$32,443
This project will require an initial investment of $35,000. If the discount rate is 12%, what is the projects NPV? a. b. c. d. -$10,000 -$ 2,557 +$ 2,557 +$10,000 NPV = $32,443 - $35,000 = -$2,577
Using the CF button
Year 1 2 3 4 5
Cash flow $9,000 $9,000 $9,000 $9,000 $9,000
This project will require an initial investment of $35,000. If the discount rate is 12%, what is the projects NPV? CF0 CF01 F01 -$35,000 $9,000 5
I = 12%
NPV = -$2,557.014
Problem #2
Year 1 2 3 4 Cash flow $19,000 $29,000 $15,000 $4,000
$3,000
This project will require an initial investment of $45,000. If the discount rate is 15%, what is the projects NPV? a. b. c. d. -$7,091 -$1,566 +$1,566 +$7,091
Problem #2
Year 1 2 3 4 Cash flow $19,000 $29,000 $15,000 $4,000
$3,000
This project costs $5,000. What is the payback period of the project?
Year 1 2 3 4 5 6 7 Cash flow $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $999,950 a. b. c. d. 3 4 5 7 years years years years
Chapter 8 1-4, 13-20

Answers on BB
Problem in class
Year 1 2 3 4 Cash flow $38,000 $19,000 $26,000 $1,000
$5,000
IRR The internal rate of return is the discount rate that makes the present value of the future cash flows = the cost of the project
Meaning, the rate where NPV = 0
IRR Example:
A project costs $5,000 will provide cash flows of $3,000 per year for 3 years What is the IRR of this project?
$5,000 = $3,000 $3,000 + 1 + 1 +
2+
$3,000 1 +
Solve this equation for the IRR No easy way to solve this. Trial and error or use a computer/calculator
IRR Example:
A project costs $5,000 and will provide cash flows of $3,000 per year for 3 years What is the IRR of this project?
$5,000 = $3,000 $3,000 + 1 + 1 +
2+
$3,000 1 +
Since the cash flows are constant, this is like an annuity, so you can solve it on the calculator N 3 I ? PV -5,000 PMT 3,000 FV 0
36.31%
The cash flows are usually not constant, so these are more difficult to solve Example:
A project costs $75,000 today. The future cash flows are projected to be:
Year 1 $65,000 Year 2 $25,000 Year 3 $10,000
What is the IRR?

$75,000 = $65,000 $25,000 $10,000 + + 1 + 1 + 2 1 + 3
Use the calculator

$65,000 $25,000 $10,000 $75,000 = + + 1 + 1 + 2 1 + 3 CF0 CF01 F01 CF02 F02 CF03 -75,000 65,000 1 25,000 1 10,000 IRR CPT IRR = 22.69%
Page 245 of your textbook has an example using your calculator
The IRR rule IF

IRR > required return
IRR < required return

This rule works as long as we are not considering mutually exclusive projects. With mutually exclusive projects, the IRR rule sometimes doesnt work.
Compare NPVs instead.
What is the IRR of the following project?

Year 0 1 2 3 CF -150,000 50,000 40,000 30,000
4 5
25,000 25,000
a. b. c. d. 5% 6% 7% 9%
What is the IRR of the following project?

Year 0 1 2 3 CF -150,000 50,000 40,000 30,000
4 5
25,000 25,000
a. b. c. d. 5% 6% 7% 9%
Project costs $3,000 and will provide cash flows of $800 per year for 6 years. The discount rate is 10%. What is the PV of the future cash flows?
A. B. C. D. $3,484 $3,529 $3,699 $3,702
Project costs $3,000 and will provide cash flows of $800 per year for 6 years. The discount rate is 10%. What is the PV of the future cash flows?
A. B. C. D. $3,484 $3,529 $3,699 $3,702 N
6
I
10
PV
? $3,484
PMT
800
FV
0
Project costs $3,000 and will provide cash flows of $800 per year for 6 years. The discount rate is 10%. What is the NPV of the project?
A. B. C. D. $484 $529 $699 $702
Project costs $3,000 and will provide cash flows of $800 per year for 6 years. The discount rate is 10%. What is the NPV of the project?
A. B. C. D. $484 $529 $699 $702 = $3,484 $3,000 = $484
Mutually exclusive projects

Different timing and size of cash flows between mutually exclusive projects may cause the IRR to give you the wrong conclusion Example, page 245 of your textbook (r=7%)
0 1 400,000 25,000 2 0 25,000 3 0 475,000
Initial
Revised
-350,000 -375,000
The IRR of the Initial project is: 14.29%

What is the IRR of the revised project?
a. b. c. d.
8.76% 9.22% 12.56% 18.22%

Different timing and size of cash flows between mutually exclusive projects may cause the IRR to give you the wrong conclusion Example, page 245 of your textbook (r=7%)
0 1 400,000 25,000 2 0 25,000 3 0 475,000
Initial
Revised
-350,000 -375,000
What is the IRR of the revised project?

N 3 I ? PV -375000 PMT 25,000 FV 450,000
a. b. c. d.
8.76% 9.22% 12.56% 18.22%
12.56%

Different timing and size of cash flows between the projects may cause the IRR to give you the wrong conclusion Example, page 245 of your textbook (r=7%)
0 1 400,000 25,000 2 0 25,000
$400,000 1+7%
3 0 475,000
IRR 14.29% 12.56%
Initial
-350,000 -375,000
Revised
The NPV of the initial project is:
$350,000 = $23,832 a. b. c. d. 57,942 60,888 68,540 70,500
What is the NPV of the revised project?

0 1 400,000 25,000 2 0 25,000 3 0 475,000 IRR 14.29% 12.56%
Initial
-350,000 -375,000
Revised
What is the NPV of the revised project?

N 3 I 7 PV ? PMT 25,000 FV 450,000
432,942
432,942 375,000 = 57,942

0 1 400,000 25,000 2 0 25,000 3 0 475,000 IRR 14.29% 12.56% NPV +23,832 +57,942
Initial
-350,000 -375,000
Revised
The Initial project has a higher IRR, but a smaller NPV This is because the interest rates are low enough that the large payment received in year 3 still has considerable PV. This is not true at higher rates.
Because the timing and size of those cash flows are so different, the NPV changes a lot as the discount rate changes
The initial proposal gets a lot of cash early, so it is better at high discount rates The revised proposal gets a lot of cash later, so it is better at lower discount rates
150,000
100,000
NPV Initial NPV Revised

50,000
0 0% 5% 10% 15% 20% 25%
-50,000
Remember: When comparing mutually exclusive projects, focus on the NPVs, because the IRR can lead you to the wrong decision.
-100,000
It is possible for a project to have more than one solution to the IRR equation
This occurs when the project has both inflows and outflows of cash (the cash flows change sign) Use the NPV
It is OK to make a yes/no decision about a single project with conventional cash flows using IRR
If IRR > Discount rate
If IRR < Discount rate
When comparing mutually exclusive projects, however, it isnt always correct to pick the one with the higher IRR
Compare the NPVs
Project selection
Which mutually exclusive project would you select, if both are priced at $1,000 and your discount rate is 15%: Project A with three annual cash flows of $1,000; or project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A. Project A. B. Project B. C. You are indifferent since the NPVs are equal. D. Neither project should be selected. Find the NPV of each project and choose the one with the higher NPV
Project selection, both cost $1,000

Project A Project B
$1,000
$1,000 $1,000
$0
$0 $0 $1,500 $1,500 $1,500
Project A
N 3
I 15%
PV ?
$2,283.23
PMT $1,000
FV 0
NPV = $1,283.23

Project A $1,000 $1,000 $1,000 Project B $0 $0 $0 $1,500 $1,500 $1,500
Project B
N
3
I
15%
PV
? $3,424.84
PMT
$1,500
FV
0 $3,424.84 = $2,251.89 1 + 15% 3
NPV = $1,251.89

Project A B NPV $1,283.23 $1,251.89
NPVA > NPVB, so choose project A
Example page 236 Your need to buy a new machine. You can choose between to models:
Cost Deluxe Budget $15,000 $10,000 1 4 6 2 4 6 3 4 -
Rates are 6%. Which is the better deal? We cannot compare NPVs in this case, because the machines have unequal lives
We will have to buy another the Budget model in 2 years, another Deluxe model in 3.
Equivalent annual annuity

Find the annual operating cost of each machine What is the average annual cost of operating each machine? Machine A costs $15,000 today, then $4,000 per year for 3 years. This is a total cost today of:
= 15,000 + $4,000 $4,000 + 1 + 6% 1 + 6%
2+
$4,000 1 + 6%
= $25,692
If you were going to spread this cost out equally over 3 years, you would have 3 annual payments with a PV of $25,692
N $9,611 3 I 6 PV -25,692 PMT ? FV 0
Equivalent annual annuity

Machine B costs $10,000 today, then $6,000 per year for 2 years. This is a total cost today of:
= 10,000 + $6,000 $6,000 + 1 + 6% 1 + 6%
2
= $21,000
If you were going to spread this cost out equally over 2 years, you would have 2 annual payments with a PV of $21,000
N 2 I 6 PV -21,000 $11,454 The Deluxe cost is $9,610 per year, so it is a better deal. PMT ? FV 0
Problem 3, page 238 in the textbook

Old machine
Will last 2 more years, costs $12,000 per year
New machine
Costs $25,000 now, then $8,000 per year, lasts 5 yrs R = 6%
Should you buy the new machine now, or wait two more years? What is the equivalent annual cost of the new machine? New machine N I PV PMT FV
?
$33,699
8,000
This is the PV of the future costs

Old machine
New machine
Costs $25,000 now, then $8,000 per year, lasts 5 yrs New machine R = 6%
$33,699 This is the PV of the future costs
Equivalent annual annuity will spread the operating costs plus the purchase cost over the life of the machine N 5 I 6 PV $58,698 PMT ? $13,935 FV 0

Old machine
New machine
Costs $25,000 now, then $8,000 per year, lasts 5 yrs R = 6%
Machine Old New Annual costs $12,000 $13,935
The new machine will cost more per year, so keep the old machine
What is the equivalent annual annuity (EAA) for a machine that costs $15,000 to purchase today, costs $4,000 per year to operate, and is expected to last for 6 years?
Rates are 9%.
a. b. c. d. $6,588 $7,012 $7,344 $8,122
1. Find the PV of the future costs 2. Add (1) to the cost to purchase to get the total cost today 3. Find the PMT you can get from (2)
Rates are 9%.
a. b. c. d. $6,588 $7,012 $7,344 $8,122 N 6 I 9 PV ? $17,943.67
PV of future payments PMT 4000 FV 0
Rates are 9%.
a. b. c. d. $6,588 $7,012 $7,344 $8,122 PV of future payments $17,943.67
Total cost today
$15,000 + $17,943.67 = $32,943.67
Rates are 9%.
a. b. c. d. $6,588 $7,012 $7,344 $8,122 PV of future payments $17,943.67 Total cost today $15,000 + $17,943.67 = $32,943.67 EAA of all costs N 6 I 9 PV 32,943.67 PMT ? FV 0
What is the minimum cash flow that could be received at the end of year 3 to make the following project acceptable?
Initial cost Cash flow end of year 1 Cash flow end of year 2 Cash flow end of year 3 = = = = $100,000 $ 35,000 $ 35,000 $?
The discount rate = 10%.

To make the project acceptable, the NPV > 0. PV(future cash flows) Cost today > 0
What is the minimum cash flow that could be received at the end of year 3 to make the following project acceptable?
Initial cost Cash flow end of year 1 Cash flow end of year 2 Cash flow end of year 3 = = = = $100,000 $ 35,000 $ 35,000 $?
The discount rate = 10%.

3 1 + 10% $35,000 3 + 1 + 10%
3
$35,000 2 + 1 + 10% $100,000 = 0
3 1 + 10%
= $39,265.20 3 = $52,250
If a projects IRR is 13% and the project provides annual cash flows of $15,000 for 4 years, how much did the project cost?
Remember that the IRR is the rate when NPV = 0 So in the case, when the discount rate = 13%
The cost = PV(4 payments of $15,000)
N
4
I
13
PV
? 44,617
PMT
15,000
FV
0
Your car requires a lot of Maintenance

$4,000 per year But it is paid for
You can replace it with a new car that costs $8,000.

The new car with require $X in maintenance per year
If you expect both vehicles to last 4 more years, how high can X be and it still be worth buying the new car?
Rates = 8%
Rates = 8%
$4,000 per year
$8,000 today, $X per year
You know the total cost per year of the old car: $4,000
You want to compare that to the cost per year of the new car
The EAA of the new car must be < $4,000
Rates = 8%
$4,000 per year
The cost of the car today is $8,000. The EAA from this amount is: N 4 I 8 PV 8,000 PMT ? FV 0
$2,415.37
This is the equivalent cost per year of the new car based only on its purchase price
Rates = 8%
$4,000 per year
The cost of the car today is $8,000. The EAA from this amount is: EAA from only the purchase price: $2,415.37 The new car must cost less than $4,000 per year to operate So the most you could spend on annual maintenance is: $4,000 - $2,415.37 = $1,584.63 Any more, and the new car is not worth it.

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Chapter 8 Part 1

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Chapter 8 Net present value

Capital means money

Budgeting means a plan

The big picture

Movies are a good example

How much money the movie will make is uncertain

Suppose you are an executive at GDL Studios.

NPV = Present value of future cash flows cost today

Is it worth it? Suppose investors require a 10% return.

$75 $15 = + 1 + 10% 1 + 10%

PV future cash flows = $98.96 million

Example 8.1, page 231: New computer

Which should you choose?

Movie 2 Romance, budget is $60 million

Which should you choose?

Find the NPV of Movie 1 A. -1.82 B. 3.25 C. 6.81 D. 9.19

Which should you choose?

$85 $25 + 1 + 10% 1 + 10%

PV = $106.81, NPV = $106.81 - $100 = $6.81

Which should you choose?

Find the NPV of Movie 1 A. 4.25 B. 7.39 C. 8.41 D. 10.97

Which should you choose?

Net present value

PV = $106.81, NPV = $106.81 - $100 = $6.81

PV = $70.97, NPV = $70.97 - $60 = $10.97

Net present value

The discount rate is 14%. What is the NPV of the project?

-$136,088 -$ 88,203 $ 44,192 $109,385

Project B -200 100 100

A. -12.18 B. - 4.92 C. 25.14 D. 48.20

Project B -200 100 100

= 248.20 200 = 48.20 A. -12.18 B. - 4.92 C. 25.14 D. 48.20

Project B -200 100 100

23.22 37.88 44.37 51.53

Project B -200 100 100

= 244.37 200 = 44.37 A. B. C. D. 23.22 37.88 44.37 51.53

Project B -200 100 100

Project B -200 100 100

What is the payback period for the new machine?

Problems with the payback method:

The payback > 3, but the NPV is >>0.

Other problems with the payback method:

The payback period is still often used

Problem #1 Year 1 2 3 4 5 Cash flow $9,000 $9,000 $9,000 $9,000 $9,000

Cash flow $9,000 $9,000 $9,000 $9,000 $9,000 PV=$32,443

Using the CF button

Cash flow $9,000 $9,000 $9,000 $9,000 $9,000

Chapter 8 1-4, 13-20

What is the IRR?

Use the calculator

The IRR rule IF

IRR < required return

Compare NPVs instead.

What is the IRR of the following project?

What is the IRR of the following project?

Mutually exclusive projects

The IRR of the Initial project is: 14.29%

8.76% 9.22% 12.56% 18.22%

Mutually exclusive projects

What is the IRR of the revised project?

8.76% 9.22% 12.56% 18.22%

Mutually exclusive projects

IRR 14.29% 12.56%