CHAPTER FIVE Understanding the 3 Worths’
2 Analysis of a project or an investment Methods of analyzing a project or an investment – Pay back period (Initial Project Screening Method) – Present/future worth analysis – Equivalent annual worth analysis – Internal rate of return – Cost benefit ratio
3 Bank Loan vs. Investment Project Bank Customer Loan Repayment Company Project Investment Return Bank Loan Investment Project
Exercise I • A company purchases equipment to improve production at a cost of $ 650,000 and expects an annual benefit of $ 215,000. maintenance costs incurred are $ 53, 000 per year resulting in a net benefit of saving of $ 162,500 for 8 years. Draw the cash flow diagram
5 Describing Project Cash Flows Year ( n ) Cash Inflows (Benefits) Cash Outflows (Costs) Net Cash Flows 0 0 $650,000 -$650,000 1 215,500 53,000 162,500 2 215,500 53,000 162,500 … … … … 8 215,500 53,000 162,500
Present worth analysis • Until the 1950s, the payback method was widely used as a means of making investment decisions. • As flaws in this method were recognized, however. Business people began to search for methods to improve project evaluations. • The result was the development of discounted cash flow techniques (DCFs), which take into account the time value of money. • One of the DCFs is the net-present- worth (or net- present value) (PW or PV) method.
Present worth analysis • A capital-investment problem is essentially a matter of determining whether the anticipated cash inflows from a proposed project are sufficiently attractive to invest funds in the project.
Present Worth Comparison • Cash flows are known. • Cash flows do not include effect of inflation. • The interest rate (discounting rate) is known. • Comparisons are made with before tax cash flows. • Comparisons do not include intangible considerations. • Comparisons do not include consideration of the availability of funds to implement alternatives. ASSUMPTIONS
Present worth analysis • As we observed, the most convenient point at which to calculate the equivalent values is often at time zero. • Under the PW criterion, the present worth of all cash inflows associated with an investment project is compared with the present worth of all cash outflows associated with that project. • The difference between the present worth‘s of these cash flows Referred to as the net present worth (PW), determines whether the project is or is not an acceptable investment. • When two or more projects are under consideration, PW analysis further allows us to select the best project by comparing their PW figures directly.
Present worth analysis • Evaluation of a Single Project – Step 1: Determine the interest rate that the firm wishes to earn on its investments. – The interest rate you determine represents the rate at which the firm can always invest the money in its investment pool. This interest rate is often referred to as either a required rate of return or a minimum attractive rate of return (MARR). Usually this selection is a policy decision made by top management.