2.cashflows
TRANSCRIPT
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CHAPTER
7
Net Present Value
and CapitalBudgeting
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Chapter Outline
7.1 Incremental Cash Flows
7.2 The Baldwin Company: An !ample
7." The Boein# 777: A $eal-%orld !ample
7.& In'lation and Capital Bud#etin#
7.( In)estments o' *ne+ual ,i)es: The+ui)alent Annual Cost ethod
7. /ummary and Conclusions
7.1 Incremental Cash Flows
7.2 The Baldwin Company: An !ample
7." The Boein# 777: A $eal-%orld !ample
7.& In'lation and Capital Bud#etin#
7.( In)estments o' *ne+ual ,i)es: The+ui)alent Annual Cost ethod
7. /ummary and Conclusions
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7.1 Incremental Cash Flows
Cash 'lows matter0not accountin# earnin#s.
/un costs dont matter.
Incrementalcash 'lows matter.Opportunity costs matter.
/ide e''ects lie canni3alism and erosion matter.
Ta!es matter: we want incremental a'ter-ta! cash'lows.
In'lation matters.
Cash 'lows matter0not accountin# earnin#s.
/un costs dont matter.
Incrementalcash 'lows matter.Opportunity costs matter.
/ide e''ects lie canni3alism and erosion matter.
Ta!es matter: we want incremental a'ter-ta! cash'lows.
In'lation matters.
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Cash Flows04ot Accountin# arnin#s
Consider depreciation e!pense.
5ou ne)er write a chec made out to
6depreciation.
uch o' the wor in e)aluatin# a pro8ect
lies in tain# accountin# num3ers and
#eneratin# cash 'lows.
Consider depreciation e!pense.
5ou ne)er write a chec made out to
6depreciation.
uch o' the wor in e)aluatin# a pro8ect
lies in tain# accountin# num3ers and
#eneratin# cash 'lows.
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Incremental Cash Flows
/un costs are not rele)ant
9ust 3ecause 6we ha)e come this 'ar does not meanthat we should continue to throw #ood money a'ter
3ad.
Opportunity costs domatter. 9ust 3ecause apro8ect has a positi)e 4; that does not mean
that it should also ha)e automatic acceptance./peci'ically i' another pro8ect with a hi#her 4;would ha)e to 3e passed up we should not
proceed.
/un costs are not rele)ant
9ust 3ecause 6we ha)e come this 'ar does not meanthat we should continue to throw #ood money a'ter
3ad.
Opportunity costs domatter. 9ust 3ecause apro8ect has a positi)e 4; that does not mean
that it should also ha)e automatic acceptance./peci'ically i' another pro8ect with a hi#her 4;would ha)e to 3e passed up we should not
proceed.
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Incremental Cash Flows
/ide e''ects matter.
rosion and canni3alism are 3oth 3ad thin#s.
I' our new product causes e!istin# customersto demand less o' current products< we need to
reco#ni=e that.
/ide e''ects matter.
rosion and canni3alism are 3oth 3ad thin#s.
I' our new product causes e!istin# customersto demand less o' current products< we need to
reco#ni=e that.
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stimatin# Cash Flows
Cash Flows 'rom Operations
$ecall that:
Operatin# Cash Flow > BIT ? Ta!es @ epreciation4et Capital /pendin#
ont 'or#et sal)a#e )alue a'ter ta!< o' course.
Chan#es in 4et %orin# Capital$ecall that when the pro8ect winds down< we en8oy a
return o' net worin# capital.
Cash Flows 'rom Operations
$ecall that:
Operatin# Cash Flow > BIT ? Ta!es @ epreciation4et Capital /pendin#
ont 'or#et sal)a#e )alue a'ter ta!< o' course.
Chan#es in 4et %orin# Capital$ecall that when the pro8ect winds down< we en8oy a
return o' net worin# capital.
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Interest !pense
,ater chapters will deal with the impact that
the amount o' de3t that a 'irm has in its
capital structure has on 'irm )alue.For now< its enou#h to assume that the
'irms le)el o' de3t hence interest e!pense
is independent o' the pro8ect at hand.
,ater chapters will deal with the impact that
the amount o' de3t that a 'irm has in its
capital structure has on 'irm )alue.For now< its enou#h to assume that the
'irms le)el o' de3t hence interest e!pense
is independent o' the pro8ect at hand.
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7.2 The Baldwin Company: An !ample
Costs o' test maretin# already spent: 2(G
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The %orsheet 'or Cash Flows
o' the Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5In)estments:
1 Bowlin# 3all machine ?1GG.GG 21.7J
2 Accumulated 2G.GG (2.GG 71.2G D2.72 E&.2&depreciation
" Ad8usted 3asis o' DG.GG &D.GG 2D.DG 17.2D (.7
machine a'terdepreciation end o' year
& Opportunity cost ?1(G.GG1(G.GGwarehouse
( 4et worin# capital 1G.GG 1G.GG 1."2 2&.E7 21.22 G end o'
year Chan#e in net ?1G.GG ?."2 ?D.( ".7( 21.22worin# capital
7 Total cash 'low o' ?2G.GG ?."2 ?D.( ".7( 1E2.EDin)estmentK1 @ & @ L
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5In)estments:
1 Bowlin# 3all machine ?1GG.GG 21.7J
2 Accumulated 2G.GG (2.GG 71.2G D2.72 E&.2&depreciation
" Ad8usted 3asis o' DG.GG &D.GG 2D.DG 17.2D (.7
machine a'terdepreciation end o' year
& Opportunity cost ?1(G.GG1(G.GGwarehouse
( 4et worin# capital 1G.GG 1G.GG 1."2 2&.E7 21.22 G end o'
year Chan#e in net ?1G.GG ?."2 ?D.( ".7( 21.22
worin# capital
7 Total cash 'low o' ?2G.GG ?."2 ?D.( ".7( 1E2.EDin)estmentK1 @ & @ L
J %e assume that the endin# maret )alue o' the capital in)estment at year ( is "G
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The %orsheet 'or Cash Flows o' the Baldwin Company
($ thousands) (All cash flows occur at the endof the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
In)estments:1 Bowlin# 3all machine ?1GG.GG 21.7J
2 Accumulated 2G.GG (2.GG 71.2G D2.72 E&.2&depreciation
" Ad8usted 3asis o' DG.GG &D.GG 2D.DG 17.2D (.7machine a'ter
depreciation end o' year& Opportunity cost ?1(G.GG
1(G.GGwarehouse
( 4et worin# capital 1G.GG 1G.GG 1."2 2&.E7 21.22 Gend o' year
Chan#e in net ?1G.GG ?."2 ?D.( ".7( 21.22worin# capital
7 Total cash 'low o' ?2G.GG ?."2 ?D.( ".7( 1E2.EDin)estmentK1 @ & @ L
1(G
At the end of the project, the warehouse s unencu!"ered, so we can sell t f we want to.
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The %orsheet 'or Cash Flows o' the
Baldwin Company continued
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
($ thousands) (All cash flows occur at the endof the year.)
$ecall that production in units 3y year durin# (-year li'e o' the machine is#i)en 3y:
(
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The %orsheet 'or Cash Flows o' the Baldwin
Company continued
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&
($ thousands) (All cash flows occur at the endof the year.)
A#ain< production in units 3y year durin# (-year li'e o' the machine is #i)en3y:
(
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The %orsheet 'or Cash Flows o' the Baldwin
Company continued
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&
1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&
1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2
($ thousands) (All cash flows occur at theend
of the year.)
epreciation is calculated usin# the AcceleratedCost $eco)ery /ystem shown at ri#ht
Our cost 3asis is 1GG 1GG 11
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The %orsheet 'or Cash Flows o' the
Baldwin Company continued
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2
11 Income 3e'ore ta!es "G.GG &".2G D(."2 7.(D "G.(&KD ? E - 1GL
12 Ta! at "& percent 1G.2G 1&.E 2E.G1 22.ED 1G."D
1" 4et Income 1E.DG 2D.(1 (."1 &&.G 2G.1
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG
E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2
11 Income 3e'ore ta!es "G.GG &".2G D(."2 7.(D "G.(&KD ? E - 1GL
12 Ta! at "& percent 1G.2G 1&.E 2E.G1 22.ED 1G."D
1" 4et Income 1E.DG 2D.(1 (."1 &&.G 2G.1
($ thousands) (All cash flows occur at the endof the year.)
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Incremental A'ter Ta! Cash Flows
o' the Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1 /ales
$e)enues
1GG.GG 1".GG 2&E.72 212.2G 12E.EG
2 Operatin#
costs
-(G.GG -DD.GG -1&(.2G 1"".1G -D7.D&
" Ta!es -1G.2G -1&.E -2E.G1 -22.ED -1G."D
& OCF
1 ? 2 ? "
"E.DG G.(1 7(.(1 (.12 "1.D
( Total CF o'
In)estment
?2G. ?."2 ?D.( ".7( 1E2.ED
IATCFK& @ (L
?2G. "E.DG (&.1E .D (E.D7 22&.
G(.(DD
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4; Baldwin Company
1
"E.DG
(1
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7." In'lation and Capital Bud#etin#
In'lation is an important 'act o' economic li'e and must 3e considered incapital 3ud#etin#.
Consider the relationship 3etween interest rates and in'lation< o'tenre'erred to as the Fisher relationship:
1 @ 4ominal $ate > 1 @ $eal $ate M 1 @ In'lation $ate
For low rates o' in'lation< this is o'ten appro!imated as
$eal $ate 4ominal $ate ? In'lation $ate
%hile the nominal rate in the *./. has 'luctuated with in'lation< most o'
the time the real rate has e!hi3ited 'ar less )ariance than the nominalrate.
%hen accountin# 'or in'lation in capital 3ud#etin#< one must comparereal cash 'lows discounted at real rates or nominal cash 'lowsdiscounted at nominal rates.
In'lation is an important 'act o' economic li'e and must 3e considered incapital 3ud#etin#.
Consider the relationship 3etween interest rates and in'lation< o'tenre'erred to as the Fisher relationship:
1 @ 4ominal $ate > 1 @ $eal $ate M 1 @ In'lation $ate
For low rates o' in'lation< this is o'ten appro!imated as
$eal $ate 4ominal $ate ? In'lation $ate
%hile the nominal rate in the *./. has 'luctuated with in'lation< most o'
the time the real rate has e!hi3ited 'ar less )ariance than the nominalrate.
%hen accountin# 'or in'lation in capital 3ud#etin#< one must comparereal cash 'lows discounted at real rates or nominal cash 'lowsdiscounted at nominal rates.
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!ample o' Capital Bud#etin# under In'lation
/ony International has an in)estment opportunity to produce a newstereo color T;.
The re+uired in)estment on 9anuary 1 o' this year is "2 million. The'irm will depreciate the in)estment to =ero usin# the strai#ht-linemethod. The 'irm is in the "& ta! 3racet.
The price o' the product on 9anuary 1 will 3e &GG per unit. Theprice will stay constant in real terms.
,a3or costs will 3e 1( per hour on 9anuary 1. The will increase at2 per year in real terms.
ner#y costs will 3e ( per T;H they will increase " per year inreal terms.
The in'lation rate is ( $e)enues are recei)ed and costs are paid atyear-end.
/ony International has an in)estment opportunity to produce a newstereo color T;.
The re+uired in)estment on 9anuary 1 o' this year is "2 million. The'irm will depreciate the in)estment to =ero usin# the strai#ht-linemethod. The 'irm is in the "& ta! 3racet.
The price o' the product on 9anuary 1 will 3e &GG per unit. Theprice will stay constant in real terms.
,a3or costs will 3e 1( per hour on 9anuary 1. The will increase at2 per year in real terms.
ner#y costs will 3e ( per T;H they will increase " per year inreal terms.
The in'lation rate is ( $e)enues are recei)ed and costs are paid atyear-end.
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!ample o' Capital Bud#etin# under In'lation
The risless nominal discount rate is &.
The real discount rate 'or costs and re)enues is D.Calculate the 4;.
The risless nominal discount rate is &.
The real discount rate 'or costs and re)enues is D.Calculate the 4;.
#ear #ear % #ear & #ear '
Physcal
Producton
(unts)
, %, %, ,
*a"or +nput(hours)
%,, %,, %,, %,,
Enery nput,
physcal unts
%, %, %, %,
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CFG
!ample o' Capital Bud#etin#
under In'lation
The depreciation ta! shield is a ris-'ree nominal cash 'low< and isthere'ore discounted at the nominal risless rate.
Cost o' in)estment today > "2 & years
Annual depreciation e!pense:
epreciation ta! shield > D
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5ear 1 A'ter-ta! $eal $isy Cash Flows
$isy $eal Cash Flowsrice: &GG per unit with =ero real price increase
,a3or: 1( per hour with 2 real wa#e increase
ner#y: ( per unit with " real ener#y cost increase
5ear 1 A'ter-ta! $eal $isy Cash Flows:A'ter-ta! re)enues >
&GG M 1GG 2G
2 2
( M 2
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5ear 2 A'ter-ta! $eal $isy Cash Flows
$isy $eal Cash Flowsrice: &GG per unit with =ero real price increase
,a3or: 1( per hour with 2 real wa#e increase
ner#y: ( per unit with " real ener#y cost increase
5ear 1 A'ter-ta! $eal $isy Cash Flows:A'ter-ta! re)enues >
&GG M 1GG 2G
2
&GG M 1GG 2G
2
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5ear " A'ter-ta! $eal $isy Cash Flows
$isy $eal Cash Flowsrice: &GG per unit with =ero real price increase
,a3or: 1( per hour with 2 real wa#e increase
ner#y: ( per unit with " real ener#y cost increase
5ear 1 A'ter-ta! $eal $isy Cash Flows:A'ter-ta! re)enues >
&GG M 1GG 721
1( M 2
2
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5ear & A'ter-ta! $eal $isy Cash Flows
$isy $eal Cash Flowsrice: &GG per unit with =ero real price increase
,a3or: 1( per hour with 2 real wa#e increase
ner#y: ( per unit with " real ener#y cost increase
5ear 1 A'ter-ta! $eal $isy Cash Flows:A'ter-ta! re)enues >
&GG M 1GG 21
1( M 2
2
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!ample o' Capital Bud#etin# under In'lation
$(
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!ample o' Capital Bud#etin#
under In'lation
The pro8ectNPVcan now 3e computed as thesum o' thePVo' the cost< thePVo' the risycash 'lows discounted at the risy rate and thePVo' the ris-'ree cash 'lows discounted at the ris-'ree discount rate.
NPV> ?"2
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7." The Boein# 777:A $eal-%orld !ample
In late 1EEG< the Boein# Company announced its
intention to 3uild the Boein# 777< a commercial
airplane that could carry up to "EG passen#ersand 'ly 7
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Ta3le 7.( Incremental Cash Flows: Boein# 777
#ear -nts
ales
Re/enue
0peratn
Costs 1ep. Ta2es
34C
Captal
pendn
+n/est5
!ent
3et Cash
6low
$89. $'. $(&7.7) $'. $'. $(7.&)
% ,&'. 9. ('88.%') 9. 9. (,'.79)
& ,%'. 9.' ('9.8) &. &. (,78.8%)
' 8'. %'.79 (&%8.%) %. %. (7.8)
' $,8'7. ,79.9 %.%8 (8%.8) 181 06
.8 8%. (%%.7)
9 ' ,'8.9 7,89.' .9 '&.8& 1 722 00 .'% ,7'.'% 98.7'
7 ' ,%''.%& 9,.' . 88. (7.%) .'% %.& ,89.7
4et Cash Flow can 3e determined in three steps:
Ta!es 1E DD(.1G
In)estment ?17.12 @ 1E.&2 > 2."G
4CF 1E 1
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1EE1 $ (7.&) 2GG2 1
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7." The Boein# 777: A $eal-%orld!ample
rior to 1EEG< Boein# had in)ested se)eralhundred million dollars in research andde)elopment.
/ince these cash out'lows were incurred prior tothe decision to 3uild the plane< they aresunkcosts.
The rele)ant costs were the at the time thedecision was made were the 'orecasted 4et CashFlows
rior to 1EEG< Boein# had in)ested se)eralhundred million dollars in research andde)elopment.
/ince these cash out'lows were incurred prior tothe decision to 3uild the plane< they aresunkcosts.
The rele)ant costs were the at the time thedecision was made were the 'orecasted 4et CashFlows
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4; ro'ile o' the Boein# 777 ro8ect
This #raph shows 4; as a 'unction o' the discount rate.
Boein# should accept this pro8ect at discount rates less than 21
percent and re8ect the pro8ect at hi#her discount rates.
This #raph shows 4; as a 'unction o' the discount rate.
Boein# should accept this pro8ect at discount rates less than 21
percent and re8ect the pro8ect at hi#her discount rates.
I$$ > 21.12
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Boein# 777
As it turned out< sales 'ailed to meet
e!pectations.
In 'airness to the 'inancial analysts atBoein#< there is an important distinction
3etween a #ood decisionand a #ood
outcome.
As it turned out< sales 'ailed to meet
e!pectations.
In 'airness to the 'inancial analysts atBoein#< there is an important distinction
3etween a #ood decisionand a #ood
outcome.
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7.& In)estments o' *ne+ual ,i)es: The
+ui)alent Annual Cost ethod
There are times when application o' the 4; rule can
lead to the wron# decision. Consider a 'actory which
must ha)e an air cleaner. The e+uipment is mandated 3y
law< so there is no 6doin# without.There are two choices:
The 6Cadillac cleaner costs &
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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts
AC with a Calculator
At 'irst #lance< the Cheapsate cleaner has a lower 4;At 'irst #lance< the Cheapsate cleaner has a lower 4;
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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts
7.& In)estments o' *ne+ual ,i)es:
The +ui)alent Annual Cost ethod
This o)erloos the 'act that the Cadillac
cleaner lasts twice as lon#.
%hen we incorporate that< the Cadillaccleaner is actually cheaper.
This o)erloos the 'act that the Cadillac
cleaner lasts twice as lon#.
%hen we incorporate that< the Cadillaccleaner is actually cheaper.
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The Cadillac cleaner time line o' cash 'lows:The Cadillac cleaner time line o' cash 'lows:
7.& In)estments o' *ne+ual ,i)es: The
+ui)alent Annual Cost ethod
-$4,000 100 -100 -100 -100 -100 -100 -100-100 -100 -100
0 1 2 3 4 5 6 7 8 10
-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500
-500 -500
0 1 2 3 4 5 6 7 8 10
The Cheapsate cleaner time line o' cash 'lows over ten years:
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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts
The +ui)alent Annual Cost ethod
%hen we mae a 'air comparison< the Cadillac is cheaper:%hen we mae a 'air comparison< the Cadillac is cheaper:
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In)estments o' *ne+ual ,i)es
$eplacement Chain$epeat the pro8ects 'ore)er< 'ind thePVo' that
perpetuity.
Assumption: Both pro8ects can and will 3e repeated.
atchin# Cycle
$epeat pro8ects until they 3e#in and end at the same
time0lie we 8ust did with the air cleaners.
ComputeNPV'or the 6repeated pro8ects.
The +ui)alent Annual Cost ethod
$eplacement Chain$epeat the pro8ects 'ore)er< 'ind thePVo' that
perpetuity.
Assumption: Both pro8ects can and will 3e repeated.
atchin# Cycle
$epeat pro8ects until they 3e#in and end at the same
time0lie we 8ust did with the air cleaners.
ComputeNPV'or the 6repeated pro8ects.
The +ui)alent Annual Cost ethod
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In)estments o' *ne+ual,i)es: AC
The +ui)alent Annual Cost ethodApplica3le to a much more ro3ust set o' circumstancesthan replacement chain or matchin# cycle.
The +ui)alent Annual Cost is the )alue o' the le)el
payment annuity that has the samePVas our ori#inal seto' cash 'lows.
NPV !"# $ "r%
%here"r% is the present )alue o' 1 per period 'or %periods when the discount rate is r.
For e!ample< the AC 'or the Cadillac air cleaner is 7(G.ED
The AC 'or the cheaper air cleaner is 7".DG which con'irmsour earlier decision to re8ect it.
The +ui)alent Annual Cost ethodApplica3le to a much more ro3ust set o' circumstancesthan replacement chain or matchin# cycle.
The +ui)alent Annual Cost is the )alue o' the le)el
payment annuity that has the samePVas our ori#inal seto' cash 'lows.
NPV !"# $ "r%
%here"r% is the present )alue o' 1 per period 'or %periods when the discount rate is r.
For e!ample< the AC 'or the Cadillac air cleaner is 7(G.ED
The AC 'or the cheaper air cleaner is 7".DG which con'irmsour earlier decision to re8ect it.
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Cadillac AC with a Calculator*se the cash 'low menu to 'ind the ; o' the 6lumpy cash 'lows.
Then use the time )alue o' money eys to 'ind a payment with thatpresent )alue.
*se the cash 'low menu to 'ind the ; o' the 6lumpy cash 'lows.
Then use the time )alue o' money eys to 'ind a payment with thatpresent )alue.
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Cheapsate AC with a Calculator
*se the cash 'low menu to 'ind the ; o' the cash 'lows.
Then use the time )alue o' money eys to 'ind a payment with thatpresent )alue.
*se the cash 'low menu to 'ind the ; o' the cash 'lows.
Then use the time )alue o' money eys to 'ind a payment with thatpresent )alue.
(
?(GG
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!ample o' $eplacement ro8ects
Consider a Bel#ian entists o''iceH he needs an autocla)e to sterili=e
his instruments. Qe has an old one that is in use< 3ut the
maintenance costs are risin# and so is considerin# replacin# this
indispensa3le piece o' e+uipment.
4ew Autocla)e
Cost > " 2G per year
$esale )alue a'ter years > 1 " 2G per year
$esale )alue a'ter years > 1 -((".2E
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!ample o' $eplacement ro8ects
!istin# Autocla)e#ear % & '
aintenance G 2GG 27( "2( &(G (GG
$esale EGG D(G 77( 7GG GG (GG
%otal "nnual #ost
!istin# Autocla)e#ear % & '
aintenance G 2GG 27( "2( &(G (GG
$esale EGG D(G 77( 7GG GG (GG
%otal "nnual #ostTotal Cost 'or year 1 > EGG M 1.1G ? D(G @ 2GG > "&G
340 435
Total Cost 'or year 2 > D(G M 1.1G ? 77( @ 27( > &"(
4&'
Total Cost 'or year " > 77( M 1.1G ? 7GG @ "2( > &7D
(20
Total Cost 'or year & > 7GG M 1.1G ? GG @ &(G > 2G
Total Cost 'or year ( > GG M 1.1G ? (GG @ (GG > G
((0
Note that the total cost o) kee*in+ an autoclave )or the )irst year includes the ,200
maintenance cost as -ell as the o**ortunity cost o) the )ore+one )uture value o) the ,00
-e didn/t +et )rom sellin+ it in year 0 less the ,'50 -e have i) -e still o-n it at year 1.
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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts
4ew Autocla)e !"#o' new autocla)e > -((".2E
!istin# Autocla)e
#ear % & '
aintenance G 2GG 27( "2( &(G (GG
$esale EGG D(G 77( 7GG GG (GG
%otal "nnual #ost
!ample o' $eplacement ro8ects
340 435 4&' (20 ((0
R%e should eep the old autocla)e until its cheaper to 3uy
a new one.
R$eplace the autocla)e a'ter year ": at that point the new
one will cost ((".2E 'or the ne!t years autocla)in# and
the old one will cost 2G 'or one more year.
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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts
7.( /ummary and Conclusions
Capital 3ud#etin# must 3e placed on an incremental3asis.
/un costs are i#nored
Opportunity costs and side e''ects matter
In'lation must 3e handled consistently
iscount real 'lows at real rates
iscount nominal 'lows at nominal rates.
%hen a 'irm must choose 3etween two machines o'une+ual li)es:
the 'irm can apply either the matchin# cycle approach
or the e+ui)alent annual cost approach.
Capital 3ud#etin# must 3e placed on an incremental3asis.
/un costs are i#nored
Opportunity costs and side e''ects matter
In'lation must 3e handled consistently
iscount real 'lows at real rates
iscount nominal 'lows at nominal rates.
%hen a 'irm must choose 3etween two machines o'une+ual li)es:
the 'irm can apply either the matchin# cycle approach
or the e+ui)alent annual cost approach.
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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts
orm Beds !ample
Consider a pro8ect to supply the *ni)ersity o' issouriwith 1G
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orm Beds !ample
The pro8ect will last 'or " years. Annual 'i!ed costs will 3e2(
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orm Beds !ample #G
%hat is the OCF in year =ero 'or this pro8ectCost o' 4ew +uipment G
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orm Beds !ample #1
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orm Beds !ample #"
$e)enue 1G 2
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(2orm Beds !ampleNPV
First< set your calculator to 1 payment per year.Then< use the cash 'low menu:First< set your calculator to 1 payment per year.Then< use the cash 'low menu:
CF2
CF1
F2
F1
CFG
2
71