Slides recommend investment course of action

Calculate Net Present Value Principles of Cost Analysis and Management © 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 • Standard: with at least 80% accuracy Condition: You are a cost advisor technician with access to all regulations/course handouts, and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors • 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 $20,000 Inflow st …in years (21 birthday) $40,000 Inflow …in 14 years (30 $60,000 Inflow …in 24 years (40 $100,000 Inflow th th birthday) birthday) Discount rate = 8% th …in 34 years (50 birthday) â Dale R Geiger 2011 Build a Timeline $ $100K K 100 90 80 70 60 50 40 30 20 10 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 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 PV Factor 4% PV of Cash Flow -20,000 * 0.962 = -19,231 -20,000 * 0.925 = -18,491 -20,000 * 0.889 = -17,780 -20,000 * 0.855 = -17,096 -20,000 * 3.630 = -$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 600 400 200 -200 Investment Savings -400 -600 -800 -1000 -1200 © 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 Check on Learning • • What does Net Present Value represent? How can it be used to evaluate investments in property, plant and equipment? © Dale R Geiger 2011 34 Practical Exercise © Dale R Geiger 2011 35 Calculate NPV Spreadsheet Use the NPV Annuity tab when cash flows are equal © Dale R Geiger 2011 36 Enter the key variables for consecutive time periods in the Cash Screenshots Flow I tab The spreadsheet calculates NPV and generates the timeline graph © Dale R Geiger 2011 37 If cash flows are non-consecutive like Rebecca’s inheritance, use the Cash Flow II tab © Dale R Geiger 2011 38 Practical Exercise © Dale R Geiger 2011 39 ... 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... 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 600 400 200 -200 Investment Savings -400... -20,000 * 3.630 = -$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