Concept of Present Value

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

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

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An Organization as a Collection of
Projects and Programs
Projects
and
Programs

F
E
D
C
B

Overall
Overall
performance
performance
in
in this
this period
period
is
is the
the combined
combined
results
results of
of
projects
projects A
A-- F.
F.

A
Time
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Concept of Present Value

Fn = P(1 + r)

If P dollars At interest For n

are invested rate of r . . . periods . . .
today . . .
You would have
Fn dollars.

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Present Value of a Cash-Flow Series

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

$100

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$100

$100

$100

$100

$100

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Discounted-Cash-Flow Analysis
Plant
Plant expansion
expansion
Equipment
Equipment selection
selection

Cost
Cost reduction
reduction

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Equipment
Equipment replacement
replacement

Lease
Lease or
or buy
buy

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Net-Present-Value Method

Prepare
Prepare aa table
table showing
showing cash
cash flows
flows for
for each
each

year,
year,

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

Compute
Compute net
net present
present value,
value,

IfIf the
the net
net present
present value
value (NPV)
(NPV) is
is positive,
positive,
accept
accept the
the investment
investment proposal.
proposal. Otherwise,
Otherwise,
reject
reject it.
it.

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Internal-Rate-of-Return Method

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

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

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Comparing the NPV and IRR Methods

Net
Net Present
Present Value
Value

The
The cost
cost of
of capital
capital is
is
used
used as
as the
the actual
actual
discount
discount rate.
rate.

Internal Rate of Return

The cost of capital is
compared to the internal
rate of return on a project.

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

To be acceptable, a
projects rate of return
must be greater than the
cost of capital.

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Comparing the NPV and IRR Methods

The
The net
net present
present value
value method
method
has
has the
the following
following advantages
advantages
over
over the
the internal
internal rate
rate of
of return
return
method
method .. .. ..
Easier
Easier to
to use.
use.

Easier
Easier to
to adjust
adjust for
for risk.
risk.

Provides
Provides more
more usable
usable
information.
information.

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Assumptions Underlying
Discounted-Cash-Flow Analysis
All cash flows are
treated as though
they occur at year end.

Cash flows are

treated as if
they are known
with certainty.

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Assumes a
perfect
capital
market.
Cash inflows are
immediately
reinvested at
the required
rate of return.

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Sensitivity Analysis
What annual cost-savings amount would
result in a zero NPV for the project?
Projected cash savings of $14,000 could fall as low as
$13,313, and the project would still be acceptable.

$50,470
3.791*

= $13,313

*n = 5, r = 10%
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Capital Budget Administration

Most organizations have an
elaborate approval process
for proposed investment
projects. The larger the cost
of a proposal, the higher in
the organization is the
authority for final approval.

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Justification of Investments in
Advanced Manufacturing Systems
Time
Time
horizons
horizons
are
are too
too
short
short

Hurdle
Hurdle
rates
rates are
are
too
too high
high

Benefits
Benefits
difficult
difficult to
to
quantify
quantify
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Bias
Bias
towards
towards
incremental
incremental
projects
projects

Greater
Greater
cash
cash flow
flow
uncertainty
uncertainty

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