Week 10 - ACCY 111 RJD Lecture 7

Required rate of return a logical investor seeking to

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Required rate of return A logical investor seeking to increase their wealth will only be prepared to make investments that will: compensate for the loss of interest (alternative return) and the purchasing power of the money invested, and for the fact that the returns expected may not materialise (i.e. the risk).
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Required rate of return The appropriate discount rate to use in NPV is the opportunity cost of finance – in effect the cost to the business of the finance to fund the investment. This will normally be a mixture of shareholders’ funds and borrowings referred to as the cost of capital .
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Net Present Value (NPV) NPV Method: NPV = PV inflows – PV outflows The present value of a cash flow (in or out) in year n = actual cash flow of year n / (1 + r)n Where: n = the year (into the future) of the cash flow; and r = the opportunity investment rate expresses as a decimal (rather than a percentage)
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Net Present Value (NPV) By way of a simple example, if you could receive $20,000 in twelve months time or a lesser amount immediately, what lesser amount would you accept? If we assume that you could invest that lesser amount today at a guaranteed (risk free) rate of 10% then the calculation would be: $20,000 / (1+0.1)1 = $18,182 Or, more simply, $18,182 today would have the same value as $20,000 in twelve month time.
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New Zealand Exotic Timbers Ltd The company has a rimu logging concession on the West Coast of the South Island. It has the opportunity to expand production over the next five years by the purchase of a new saw mill that will cost $1,000,000 but will be able to be sold at the end of the five years for $200,000. Increased production of rimu timber: next year 5,000 cubic metres year 2 10,000 cubic metres year 3 15,000 cubic metres year 4 15,000 cubic metres year 5 5,000 cubic metres
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The estimated selling price is $120 per cubic metre The estimated extraction costs are $80 per cubic metre As each cubic metre will give rise to $40 net cash flow over the proposed project cash flows will be: Immediate cost of saw mill $(1,000,000) 1 year’s time $200,000 2 year’s time $400,000 3 year’s time $600,000 4 year’s time $600,000 5 year’s time $200,000 plus disposal of saw mill $200,000 New Zealand Exotic Timbers Ltd
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Net Present Value (NPV) Net Cash Flows Calculation of PV PV Immediately cost of saw mill (1,000,000) (1,000,000) / (1 + .0 2) 0 = (1,000,000) end of year 1 net profit before depreciation 200,000 (1,000,000) / (1 + .0 2) 1 = 166,700 end of year 2 net profit before depreciation 400,000 (1,000,000) / (1 + .0 2) 2 = 277,800 end of year 3 net profit before depreciation 600,000 (1,000,000) / (1 + .0 2) 3 = 347,200 end of year 4 net profit before depreciation 600,000 (1,000,000) / (1 + .0 2) 4 = 289,400 end of year 5 net profit before depreciation 200,000 = disposal proceeds 200,000 (1,000,000) / (1 + .0 2) 5 = 160,800 1,200,000 $ 241,900 $
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Net Present Value (NPV) Year Net Cash Flows Discount Factor Present Value 0 (1,000,000) 1 (1,000,000) 1 200,000 0.833 166,600 2 400,000 0.694 277,600 3 600,000 0.579 347,400 4 600,000 0.482 289,200 5 200,000 0.402 80,400 5 200,000 0.402 80,400 1,200,000 $ 241,600 $
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Or alternatively we might show those cash flows as follows: $000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cost of sawmill (1,000) Net Profit 200 400 600 600 200 Disposal of sawmill 200 (1,000) 200 400 600 600 400 Discount factor 1 0.833 0.694 0.579 0.482 0.402 (1,000) 166.6 277.6 347.4 289.2 160.8 New Zealand Exotic Timbers Ltd
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Net Present Value (NPV) NPV Decision Rules: Accept the highest positive NPV, Reject all negative NPVs
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