Slides 2 4 recommend investment course of action based on NP

Recommend Investment Course of Action Based on NPV Calculation © Dale R Geiger 2011 You’ve just won a million dollars! Should you take the lump sum payment of $679,500 now or 20 annual payments of $50,000? © Dale R Geiger 2011 Terminal Learning Objective • Action: Recommend Investment Course of Action Based on NPV Calculation • Condition: You are training to become an ACE with access to ICAM course handouts, readings, and spreadsheet tools and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors • Standard: with at least 80% accuracy • Identify and enter relevant report data to solve Net Present Value equations using macro enabled templates and make appropriate recommendation © Dale R Geiger 2011 What is Net Present Value • “Net” refers to the result of combining multiple values • Net Pay combines wages earned (+) and payroll tax deductions (-) • Net Change in Financial Position combines Revenues (+) and Costs (-) • Net Present Value (NPV) refers to the combination of multiple discounted cash flows • A positive NPV means that the PV of the cash inflows outweighs the PV of the outflows © Dale R Geiger 2011 Multiple Cash Flows • Today is Rebecca’s 16th birthday Her inheritance is held in trust and will be paid in the following installments: • • • • $20,000 on her 21st birthday $40,000 on her 30th birthday $60,000 on her 40th birthday $100,000 on her 50th birthday • Assume a discount rate of 8% • Task: Calculate the NPV of Rebecca’s inheritance © Dale R Geiger 2011 Identify the Key Variables Cash Flows Time in Years …in years (21st birthday) …in 14 years (30th birthday) …in 24 years (40th birthday) …in 34 years (50th birthday) $20,000 Inflow $40,000 Inflow $60,000 Inflow $100,000 Inflow Discount rate = 8% © Dale R Geiger 2011 Build a Timeline $ $100K K The timeline helps us to visualize the cash flows and gives us a “reality check“ $60K $40K $20K 14 24 X-Axis = number of Years © Dale R Geiger 2011 Multiply by the PV Factors Cash Flow * PV Factor (8%) = $20,000 * 0.6806 = $40,000 * 0.3405 = $60,000 * 0.1577 = $100,000 * 0.0730 = Present Value Total The NPV of Rebecca’s inheritance is $43,994 © Dale R Geiger 2011 Multiply by the PV Factors Cash Flow * PV Factor (8%) = $20,000 * 0.6806 = $40,000 * 0.3405 = $60,000 * 0.1577 = $100,000 * 0.0730 = Present Value $13,612 Total The NPV of Rebecca’s inheritance is $43,994 © Dale R Geiger 2011 Multiply by the PV Factors Cash Flow * PV Factor (8%) = Present Value $20,000 * 0.6806 = $13,612 $40,000 * 0.3405 = 13,620 $60,000 * 0.1577 = $100,000 * 0.0730 = Total The NPV of Rebecca’s inheritance is $43,994 © Dale R Geiger 2011 10 Annuity = Equal Cash Flows Year Cash Flow -20,000 -20,000 -20,000 -20,000 * * * * PV Factor 4% + 0.962 + 0.925 + 0.889 + 0.855 = 3.630 = = = = PV of Cash Flow -19,231 -18,491 -17,780 -17,096 • The sum of the four factors is called the Annuity Factor • The Annuity Factor can be found on the PV Annuity Table © Dale R Geiger 2011 24 Using the PV Annuity Table The PV Annuity factor on the table is equal to the sum of the PV factors for a single cash flow for Year through Year © Dale R Geiger 2011 25 Annuity = Equal Cash Flows Year Cash Flow -20,000 -20,000 -20,000 -20,000 -20,000 * * * * * PV Factor 4% 0.962 0.925 0.889 0.855 3.630 = = = = = PV of Cash Flow -19,231 -18,491 -17,780 -17,096 -$72,600 • The PV of an Annuity is equal to: Cash flow* PV Annuity Factor © Dale R Geiger 2011 26 Make a Recommendation • Another course of action is available: Pay $70,000 cash for the machine today • Which course of action should we take? • What if the discount rate is 2%? What if it is 6%? • What other factors might be considered? © Dale R Geiger 2011 27 Make a Recommendation • Another course of action is available: Pay $70,000 cash for the machine today • Which course of action should we take? • What if the discount rate is 2%? What if it is 6%? • What other factors might be considered? © Dale R Geiger 2011 28 Check on Learning • What is an annuity? • How does an annuity simplify the NPV calculation? © Dale R Geiger 2011 29 Net Present Value • Reengineering a business process in your unit will cost $1 million now but will save an estimated $400,000 per year for the next three years • Assuming a discount rate of 10%, what is the NPV of this course of action? © Dale R Geiger 2011 30 Build a Timeline 1000s X axis represents time in years © Dale R Geiger 2011 31 Using the PV Annuity Table -Initial Investment +( Cash Flow *Annuity Factor) = NPV -1,000,000 +( 400,000*2.487) = -5,200 © Dale R Geiger 2011 32 Should we proceed with Reengineering? • NPV is negative, so we should not proceed • The present value of the benefits to be received in the future is less than the initial investment • What if the discount rate is 8%? -Initial Investment + Cash Flow (Savings) *Annuity Factor = NPV -1,000,000 + 400,000*2.577 = 30,800 © Dale R Geiger 2011 33 Practical Exercise © Dale R Geiger 2011 34 Calculate NPV Spreadsheet Use the NPV Annuity tab when cash flows are equal © Dale R Geiger 2011 35 Screenshots Enter the key variables for consecutive time periods in the Cash Flow I tab The spreadsheet calculates NPV and generates the timeline graph © Dale R Geiger 2011 36 If cash flows are non-consecutive like Rebecca’s inheritance, use the Cash Flow II tab © Dale R Geiger 2011 37 Practical Exercise © Dale R Geiger 2011 38 ... Course of Action Based on NPV Calculation • Condition: You are training to become an ACE with access to ICAM course handouts, readings, and spreadsheet tools and awareness of Operational Environment... won a million dollars! Should you take the lump sum payment of $679,500 now or 20 annual payments of $50,000? © Dale R Geiger 2011 Terminal Learning Objective • Action: Recommend Investment Course. .. PV of Cash Flow -19,231 -18,491 -17,780 -17,096 -$72,600 • The PV of an Annuity is equal to: Cash flow* PV Annuity Factor © Dale R Geiger 2011 26 Make a Recommendation • Another course of action