© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Concept of Present Value

Business investments extend over long Business investments extend over long periods of time, so we must recognize the periods of time, so we must recognize the time value of moneytime value of money..

Investments that promise returns earlier in Investments that promise returns earlier in time are preferable to those that promise time are preferable to those that promise returns later in time.returns later in time.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

An Organization as a Collection of Projects and Programs

TimeTimeAA

BB

CC

DD

EE

FF

ProjectsProjectsandand

ProgramsPrograms

Overall performancein this period

is the combinedresults of

projects A - F.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Concept of Present Value

FFnn = P(1 + r) = P(1 + r)nn

If PP dollars are invested

today . . .

At interest rate of rr . . .

For nn periods . . .

You would have FFnn dollars.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Present Value of a Cash-Flow Series

11 22 33 44 55 66

$100$100 $100$100 $100$100 $100$100 $100$100 $100$100

An investment that involves a series of identical cash An investment that involves a series of identical cash flows at the end of each year is called an flows at the end of each year is called an annuityannuity..

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Discounted-Cash-Flow Analysis

Cost reductionCost reduction

Plant expansionPlant expansion

Equipment selectionEquipment selection

Lease or buyLease or buy

Equipment replacementEquipment replacement

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Net-Present-Value Method

Prepare a table showing cash flows for each Prepare a table showing cash flows for each year,year,

Calculate the present value of each cash flow Calculate the present value of each cash flow using a discount rate,using a discount rate,

Compute net present value,Compute net present value, If the net present value (NPV) is positive, If the net present value (NPV) is positive,

accept the investment proposal. Otherwise, accept the investment proposal. Otherwise, reject it.reject it.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Internal-Rate-of-Return Method

The internal rate of return is the true The internal rate of return is the true economic return earned by the asset over economic return earned by the asset over its life.its life.

The internal rate of return is computed by The internal rate of return is computed by finding the discount rate that will cause the finding the discount rate that will cause the net present value of a project to be zero.net present value of a project to be zero.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Comparing the NPV and IRR Methods

Internal Rate of ReturnInternal Rate of Return The cost of capital is The cost of capital is

compared to the internal compared to the internal rate of return on a project.rate of return on a project.

To be acceptable, a To be acceptable, a project’s rate of return project’s rate of return must be greater than the must be greater than the cost of capital.cost of capital.

Net Present ValueNet Present Value The cost of capital is The cost of capital is

used as theused as the actual actual discount rate.discount rate.

Any project with a Any project with a negative net present negative net present value is rejected.value is rejected.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Comparing the NPV and IRR Methods

The net present value method The net present value method has the following advantages has the following advantages over the internal rate of return over the internal rate of return

method . . .method . . . Easier to use.Easier to use. Easier to adjust for risk.Easier to adjust for risk. Provides more usable Provides more usable

information.information.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Assumptions Underlying Discounted-Cash-Flow Analysis

All cash flows areAll cash flows aretreated as thoughtreated as though

they occur at year end.they occur at year end.

Cash flows are Cash flows are treated as iftreated as if

they are knownthey are knownwith certainty.with certainty.

Cash inflows areCash inflows areimmediatelyimmediatelyreinvested atreinvested atthe requiredthe required

rate of return.rate of return.

Assumes aAssumes aperfectperfectcapitalcapitalmarket.market.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Sensitivity Analysis

What annual cost-savings amount would What annual cost-savings amount would result in a zero NPV for the project?result in a zero NPV for the project?

Projected cash savings of $14,000 could fall as low asProjected cash savings of $14,000 could fall as low as$13,313, and the project would still be acceptable.$13,313, and the project would still be acceptable.

*n = 5, r = 10%*n = 5, r = 10%

$50,470$50,470 3.791*3.791* = $13,313= $13,313

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Capital Budget Administration

Most organizations have an Most organizations have an elaborate approval process elaborate approval process

for proposed investment for proposed investment projects. The larger the cost projects. The larger the cost of a proposal, the higher in of a proposal, the higher in

the organization is the the organization is the authority for final approval.authority for final approval.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

Justification of Investments in Advanced Manufacturing Systems

HurdleHurdlerates arerates aretoo hightoo high

TimeTimehorizonshorizonsare tooare tooshortshort

BiasBiastowardstowards

incrementalincrementalprojectsprojects

GreaterGreatercash flowcash flow

uncertaintyuncertainty

BenefitsBenefitsdifficult todifficult toquantifyquantify