Transcript Discounted Cash Flow Analysis

Discounted Cash Flow
Analysis
Lecture No.16
Chapter 5
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Net Present Worth Measure
 Principle: Compute the equivalent net surplus at n = 0 for a given
interest rate of i.
 Decision Rule for Single Project Evaluation: Accept the project if the
net surplus is positive.
Decision Rule for Comparing Multiple Alternatives: Select the
alternative with the largest net present worth.
Inflow
0
1
2
3
4
Outflow
PW(i)inflow
0
PW(i)outflow
Contemporary Engineering Economics, 4th
edition, © 2007
5
Net surplus
PW(i) > 0
Example 5.5 - Tiger Machine Tool Company
inflow
$24,400
$27,340
0
outflow
1
$55,760
2
3
$75,000
PW (15%) inflow  $24,400( P / F ,15%,1)  $27,340( P / F ,15%,2)
$55,760( P / F ,15%,3)
 $78,553
PW (15%) outflow  $75,000
PW (15%)  $78,553  $75,000
 $3,553  0, Accept
Contemporary Engineering Economics, 4th
edition, © 2007
Excel Solution:
1
2
3
4
5
6
7
A
Period
0
1
2
3
B
Cash Flow
($75,000)
$24,400
$27,340
$55,760
PW(15%)
$3,553.46
C
=NPV(15%,B3:B5)+B2
Contemporary Engineering Economics, 4th
edition, © 2007
Present Worth Amounts at Varying Interest Rates
i (%)
PW(i)
i(%)
PW(i)
0
$32,500
20
-$3,412
2
27,743
22
-5,924
4
23,309
24
-8,296
6
19,169
26
-10,539
8
15,296
28
-12,662
10
11,670
30
-14,673
12
8,270
32
-16,580
14
5,077
34
-18,360
16
2,076
36
-20,110
0
38
-21,745
-751
40
-23,302
17.45*
18
*Break even interest rate
Contemporary Engineering Economics, 4th
edition, © 2007
Present Worth Profile
Contemporary Engineering Economics, 4th
edition, © 2007
How To Use Cash Flow Analyzer
Output or
Analysis
results
Cash Flow
Input Fields
Graphical
Plots
Contemporary Engineering Economics, 4th
edition, © 2007
Solving Example 5.3 with Cash Flow
Analyzer
Payback
period
Project
Cash
Flows
Net
Present
Worth
Net
Future
Worth
Contemporary Engineering Economics, 4th
edition, © 2007
Obtaining a Graphical Plot of NPW
NPW plot
Between
0% and
100%
Specify the
Range of
Interest
Rate to plot
Contemporary Engineering Economics, 4th
edition, © 2007
Can you explain what $3,553
really means?
1.
2.
Project Balance Concept
Investment Pool Concept
Contemporary Engineering Economics, 4th
edition, © 2007
Project Balance Concept



Suppose that the firm has no internal funds to
finance the project, so will borrow the entire
investment from a bank at an interest rate of
15%.
Then, any proceeds from the project will be
used to pay off the bank loan.
Then, our interest is to see if how much
money would be left over at the end of the
project period.
Contemporary Engineering Economics, 4th
edition, © 2007
Project Balance Concept
N
Beginning
Balance
0
Interest
1
2
3
-$75,000
-$61,850
-$43,788
-$11,250
-$9,278
-$6,568
Payment
-$75,000
+$24,400
+$27,340
+$55,760
Project
Balance
-$75,000
-$61,850
-$43,788
+$5,404
Net surplus
PW(15%) = $5,404 (P/F, 15%, 3) = $3,553
Contemporary Engineering Economics, 4th
edition, © 2007
Project Balance Diagram
60,000
Terminal project balance
(net future worth, or
project surplus)
40,000
Project balance ($)
20,000
$5,404
0
Discounted
payback period
-$43,788
-20,000
-40,000
-60,000
-$75,000
-$61,850
-80,000
-100,000
-120,000
0
1
2
Year(n)
Contemporary Engineering Economics, 4th
edition, © 2007
3
Investment Pool Concept



Suppose the company has $75,000. It has two
options. (1)Take the money out and invest it in the
project or (2) leave the money in the pool and
continue to earn a 15% interest.
If you take Option 1, any proceeds from the project
will be returned to the investment pool and earn
15% interest yearly until the end of the project
period.
Let’s see what the consequences are for each
option.
Contemporary Engineering Economics, 4th
edition, © 2007
Meaning of Net Present Worth
N=3
How much would you have if the
Investment is made?
Investment pool
$24,400(F/P,15%,2) = $32,269
$27,340(F/P,15%,1) = $31,441
$55,760(F/P,15%,0) = $55,760
$119,470
$75,000
$55,760
How much would you have if the
investment was not made?
$75,000(F/P,15%,3) = $114,066
$27,340
$24,400
Project
What is the net gain from the
investment?
0
1
2
3
$119,470 - $114,066 = $5,404
PW(15%) = $5,404(P/F,15%,3) = $3,553
Contemporary Engineering Economics, 4th
edition, © 2007
What Factors Should the Company Consider in Selecting
a MARR in Project Evaluation?


The required return necessary to
make an investment project
worthwhile.
Viewed as the rate of return that a
firm would receive if it invested its
money someplace else with a
similar risk
Risk premium

The additional risk associated with
the project if you are dealing with a
project with higher risk
Contemporary Engineering Economics, 4th
edition, © 2007
Cost of capital

Risk
premium
Cost of capital
MARR
