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Chap006 - Oct 24th Lecture

# Chap006 - Oct 24th Lecture - 6.4 Other Methods for...

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7-0 6.4 Other Methods for Computing OCF Bottom-Up Approach Works only when there is no interest expense OCF = NI + depreciation Top-Down Approach OCF = Sales – Costs – Taxes Do not subtract non-cash deductions Tax Shield Approach OCF = (Sales – Costs)(1 – T) + Depreciation*T

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7-1 6.5 Investments of Unequal Lives There are times when application of the NPV rule can lead to the wrong decision. Consider a factory that must have an air cleaner that is mandated by law. There are two choices: The Cadillac cleaner costs \$4,000 today, has annual operating costs of \$100, and lasts 10 years. The Cheapskate cleaner costs \$1,000 today, has annual operating costs of \$500, and lasts 5 years. Assuming a 10% discount rate, which one should we choose?
7-2 Investments of Unequal Lives This overlooks the fact that the Cadillac cleaner lasts twice as long. When we incorporate the difference in lives, the Cadillac cleaner is actually cheaper (i.e., has a higher NPV).

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7-3 Equivalent Annual Cost (EAC) The EAC is the value of the level payment annuity that has the same PV as our original set of cash flows. For example, the EAC for the Cadillac air cleaner is \$750.98. The EAC for the Cheapskate air cleaner is \$763.80, thus we should reject it.
7-4 Equivalent Annual Cost (EAC) The EAC is the value of the level payment annuity that has the same PV as our original set of cash flows. For example, the EAC for the Cadillac air cleaner is \$750.98. The EAC for the Cheapskate air cleaner is \$763.80, thus we should reject it.

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7-5 7.3 Inflation and Capital Budgeting Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher equation: (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
7-6 Inflation and Capital Budgeting For low rates of inflation, this is often approximated: Real Rate Nominal Rate – Inflation Rate While the nominal rate in the U.S. has fluctuated with inflation, the real rate has generally exhibited far less variance than the nominal rate. In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.

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7-7 Chapter Outline 7.1 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis 7.2 Monte Carlo Simulation 7.3 Real Options 7.4 Decision Trees
7-8 7.1 Sensitivity, Scenario, and Break-Even Each allows us to look behind the NPV number to see how stable our estimates are.

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Chap006 - Oct 24th Lecture - 6.4 Other Methods for...

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