Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
r-Er
FRANKLIN J. STERMOLE
PRopEssoR EuERrrus,
Col_lecr op Law
*
+j
Franklin J. Stermole,8.S., M.S., Ph.D., Chemical Engineering, Iowa State University, is Professor Emeritus of Mineral Economics and Chemical and Petroleum Refining at Colorado School of Mines where he has taught since 1963. Frank also serves as
Chairman of Investment Evaluations Corporation. He has taught economic evaluation
techniques for over 30 years tri undergraduate and graduate students and has done
economic evaluation consulting for numerous mineral and non-mineral companies.
Since 1970 when the first short course was prcsented, Frank has taught more than 650
"Economic Evaluation" short courses to over 16,000 persons from mineral and nonmineral industry companies and govemment agencies. In addition to the United States
these courses have been presented in Armenia, Australia, Canada, Colombia, Egypt,
France, Germany, Great Britain, Guyana, Indonesia, Kazakhstan, Kuwait, Mexico,
Norway, Philippines, Saudi Arabia, S-outh Africa, Trinidad and Venezuela. This
domestic and foreign industrial consulting and teaching experience has had a direct
eft'ect on the applications-oriented content and organization of the text.
John N{. Stermole, B.S.B.A., Finarce, University of Denver, and M.S., Mineral
Economics, Colorado School of Mines, is President of Investment Evaluations Corporation. Since 1988 John has taught as an Instructor at Colorado School of Mines for the
Departments of Mineral Economics, Chemical And Petroleum Refining Engineering
and Environmental Sciences. John has also served as a Fellow to the Institute for
Globai Resources Policy at Colorado School of Mines, and was co-author in the 1st
Edition of the Global Mining Taxation Comparative Study. Since 1997 John has also
taught as an Adjunct Professor at The University of Denver, College of Law in the
Natural Resources and Environmental Law Program. John has presented more than
250 "Economic Evaluation" short courses for mineral, petroleum and non-mineral
companies and govemment agencies. In addition to the United States, these courses
have been presented in AustrrLlia, Canada, Chile, Colombia, Indonesia, South Africa,
Srvitzerland and the United Arab Emirates. Prior to joining Investment Evaluations
Corporation on a full tirne basis, John gained three years of industry experience with
I
I
Trademarks:
All rights reserved. No Part of This Text May be Reproduced in Any Form
Without Permission in Writing from Investment Evaluations Corporation
ISBN r-878740-09-1
Library of Congress Control Number 00-134613
Printed in the United States of America
TABLE OF CONTENTS
t
Page
l.l
1.2
1.3
1.4
1.5
.6
1.7
1
I
3
4
6
9
t2
t3
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.1
Introduction to Equivalence
Compound Interest Formula Derivations and Illustrations
Nominal, Period and Effective Interest Rates Based on
Discrete Compounding of Interest
Nominal, Period and Effective Interest Rates Based on
Continuous Compounding of Interest
Applications of Compound Interest Formulas
'Add-On" or "Flat" Interest (Applied to the Rule of 78)
"Loan Points" and Buying Down Interest
Arithmetic Gradient Series
Alternative Time Line Diagrarn and the Concept of Cash Flow
Introduction to Rate of Return Analysis
Summary
15
L6
26
29
36
4t
44
46
49
5l
52
3.1
3.2
3.3
3.4
3.5
:1.6
3.7
3.8
3.9
3.10
3.I
lntroduction
62
63
72
and Salvage, L
Rate of Return on Bond Investments
Rate of Return Related to T-Bill Discount Rates
Financial Cost of Capital vs Opportunity Cost of Capital
Rate of Return and the Revenue Reinvestment Question
Growth Rate of Return
Net Present Value, Net Annual Value, and Net Future Value lMethods of Analysis
Benefit-Cost Ratio and Present Value Ratio
3.1
80
82
86
8'7
93
98
r03
112
122
124
r32
t36
t39
117
i.18
+.
1?
:t.-3
4.10
4.ll
144
148
164
170
t82
185
189
193
t94
201
219
221
234
5.1
1?
5.3
246
271
276
I Introduction
Anail sis to Analyze Efl'ects ol.Uncerrainty
I : Scnsiriviry
n
I
]hg Ralrre Approach to Sensiriviry AnalS.sis
5.,1 Prob:rbilisricScnsitivityAnalvsis
6 5, Expected \hlue Analyiis (Economic Risk Analysis)
Expecred NPV, Expected pVR, and Expected ROR
99
6-7 Probability of Survival (Financial RiskAnalysis) Analysis
6.8 Risk Due to Natural Disaster
6.9 Option Pricing Theory Related to ENpV
6.
6.10
Summary
282
284
287
288
296
299
311
Jl-1
315
320
7.1
7.2
7.3
7.,1
75
Introduction
326
328
330
335
337
340
a^1
343
344
350
3s0
351
352
.8
'.9
'.10
'.ll
Amortization
357
361
Introduction
Forms of Business Organizations and Tax Considerations
Corporate and Individual Federal Income Tax Rates
Corporate and Individual Capital Gains Tax Treatment
Tax Treatment of Investment Terminal (Salvage) Value
Alternative Minimum Tax
Effective Tax Rates for Combined State and Federal Income Tax
8.10
8.1
8.12
Tax Credits
Discounted Cash Flow Rate of Return (DCFROR), Net Present Value,
(NPV) and Ratio AnalYsis
Working Capital
Intemational Project Evaluation Considerations
Mining and Petroleum Project After-Tax Analysis
9.1
9.2
9.3
9.4
9.5
9.6
9.1
Introduction
Payback Perioo Analysis
Savings are Analogous to Income
Sunk Costs and Opportunity Costs in Evaluations
Break-evenAnalysis
Three Methods of Investment Valuation
NPV Use For Break-even Acquisition Cost Valuation
9;7a NPV Use for Break-even Sale Value Analysis
9.8 Valuation of Pubtic Projects and Investments
9.9 Tax Analysis Versus Financial (Shareholder Report) Analysis
9.10 Net Income Analysis Cornpared to Cash Flow Analysis
9.10a "Economic Value Added" Net Income Analysis
9. l1 "Regulated" Company Investment Analysis
10.1
10.2
10.3
lO.4
10.5
l0-6
General ReplacementPhilosophy
Leasing Compared to Purchasing
Sunk Costs and Opportunity Costs Related to Replacement
Evaluation of Alternatives That Provide Different Service
Unequal Life Service-Producing Alternatives
Optimum Replacement Life for Equipment
lI
366
Summary
i. I
1.2
t.3
1.4
1.5
3.6
3.1
3.8
8.9
359
?
378
379
380
383
384
391
394
395
398
106
415
419
436
437
443
445
451
460
462
467
469
4't0
478
483
490
505
513
529
534
540
543
553
562
567
s69
573
576
578
584
12.l
Itrroducrion
12.2
12.3
,_i89
:r)3
600
604
607
609
611
614
6r6
625
627
633
635
bJv
642
649
6'10
Information
SELECTED REFERENCES
Factors
Analysis
Development
6E2
696
7O"l
709
710
INDEX
7t3
vil
PREFACE
This textbook represents the ongoing efforts and interests of a father and
son who have worked together at various times and in varying amounts for
over twenty years. The original versions of this text were the sole efforts of
Frank Stermole. John began making some contributions as early as the
Fourth Edition, but more significant contributions began with the Sixth Edition. While some might view writing a book as a difficult task, we have
truly enjoyed the opportunity to work together and try to improve our
understanding of economic evaluation concepts through the textbook and its
examples and problems.
This text is an introduction to the concepts of the time value of money
and the application of time value of mbney decision criteria to the beforetax and after-tax evaluation of virtually all types of investment situations.
We would like to emphasize that the concepts to be developed throughout
the text are used by investors in all investment situations. Other than the
obvious engineering differences, whether you are considering development
or expansion of an existing ore body, coal deposit, oil and gas field, or considering refining projects or a real estate investment, the same economic
evalnations
are
Ti;e material covered in the text is applicable for students in all engineering
drsciplines, geology, geophysics, business, accounting, finance, management,
ihis tcxtbook
s.
seilester course in which all the material from chapters one throush
tioned categories. The examples and problems throughout the text are
designed with this in mind as they address specific e'aluation consideratiols ibr a variety of industry applications. Third, the text may also be used
for self-study to teach one's self economic evaluation techniques and their
proper application. To suppiement this later use, we have also written
a
"Self reaching Manual" for this textbook which specifically addresses in
a
more step-by-step process, the material in chapters one through Four
of the
textbook. If you find yourself stru_sgling with the firsr three oitbu, chapters
you might seriously consider this g0 page manual as supplemental reading.
w'e mzrke use of the Self reaching I\{anual as pre-course ieading when presenting the textbook material in a one week short course format.
As you go through the textbook, you'll find we have a common theme
centered on "consistency" throughout the evaluation process. Expanding
on
this simply implies that evaluators must compare projects and alternatives
on the same basis. This means making a proper analysis for the evaluation
situation and being consistent in terms of discount rates, timing, the type
of
In most investment decision making situations, you will find that proper
application of the concepts and techniques presented in the text together
with a little common sense and good management judgment will enable you
to do a better job of economic. investment dec,ision-making"than you can
achieve without using these methods.
Finally, we would like to offer our thanks to Pattie Stermole (John's wife)
for her eftbrts in research and editing for this latest edition of the textbook.
Frank Stermole and John Stermole
CHAPTER
1.I
illtl
1',::liiliiiir$i{i*
investment opportunities.
Most business decisions are made by choosing what is believed to be the
best alternative out of several courses of action. Problems in this area are
therefore called alternative choice problems. In many business situations,
decisions are made intuitively because systematic, quantified decision making methods are not available to weigh the alternatives. This should not be
the case for weighing the economic consideratiom related to most invest-
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1.3 Making
Decisions
Peter Drucker, in his management texts, has stated that decision making
has five distinct phases:
2. Analyzing
cerned with the three middle phases defined by Drucker. Again, this
includes presenting and illustrating methods that can be used to analyze correctly various investment situations, develop alternative solutions and the
economic analysis of these solutions. Emphasis is directed toward the fact
that econornic analysis always involves comparison of alternatives, and
determining the best way to invest available capital. From an economic
viewpoint this means we want to maximize the future profit that can be
accumulated from the available investment dollars.
Economic evaluation decision making relates to two basic classifications
of projects or investments:
1. Revenue producing investments
2. Service producing investments
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ir.rilitil:fi
rl;:;iiirri*
,iit
;rirlitt'{lii&l
r.t?Et
Sometimes people think a third investment classification might be "savings producing projects," but it will be illustrated in Chapter 3 that looking
at differences between the costs of providing a service by alternative methods gives the savrngs that incremental investments in the more costly iniriai
investment alternatir.es will generate. Analvsis of thes6 savings and incremental costs is just one of severai valid ways oi evaluating generai service
producing projects.
Ir4anv analvsis techniques are presented and iliustrated in this text. However, emphasis is placed on compound interest rarc of return analysis and
net present value analysis, properly applied on an after tax basis. A large
rnajority of individuals, companies and government organizations that use
tormal evaluation techniques use rate of return analysis as their primary
decision making criterion with net present value the second most used technique. There are other correct techniques for evaluating various investment
situations including future and annual value, and several ratios. These techniques are presented in the text. It is necessary in economic evaluation work
to be familiar with many dift'erent approaches to economic analysis because
eventually you will interact with people that have a wide variety of evaluation backgrounds who use or advocate widely varying economic evaluation
techniques. Familiarity with different evaluation techniques enhances communication with these people. Also, it will be shown in Chapter 4 that in
ceriain evaluation situations, methods such as net present value have significant advantages over rate of return analysis. To communicate effectively
u,ith diff-erent evaluation people you must be farniliar with the principles
and advantages or disadvantages associated with different evaluation techniques. Also, beware that when you discuss rate of return analysis with different people the chances are that the term, "rate of return", may mean
something very different to the other person than it does to you. Many different rates of return are defined in the literature, some of which follow:
return on initial investment (ROI), which may be defined as being based on
initial investment, average investment or solne other investment; return on
assets (ROA), which is also called accounting rate of return and generally is
based on the non-depreciated asset value, return on equity (ROE), which
refers to return on individual or stockholder equity capital as the basis of the
calculation; return on sales (ROS), which is not an investment rate of return
at all; and the compound interest rate of return (ROR), or discounted cash
flow rate of return on an after-tax basis (DCFROR) which is analogous to a
bank account or mortgage interest rate and is the interest rate that makes
project costs and revenues equivalent at a given point in time. Only this lat-
,iG
,,ii
It is imperative
iutrrir;,rrir...ili{rs
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greater value than a doiiar at some future tin-ie because a doliar in hand
trrday can be put to work now in a bank account or other investments to
accrue interest, or refurn on investment. Compound interest is the generally
iicccpted approach today for calcuiaring accrucd interest, or returil on
il".'ritment. in time ."'alue of money calculatiors. TIle fut'-:re value thal is
prolected to be accrued trom the investurent of dollars toei:r1' at a speciiied
compounci interest rate is equal to the sum of the accrued interest and the
initial doilars lprincipal.l invested. The concept oi present worth is just the
o1-''posite of compounding. The present worth of a future value is the sum of
rironey that invested today, at a specified compound interest rate, would
grow to the given future value. when you are working with positive interest
rates, present values are always less than future values. Since the term "discounting" implies reducing the value of something, the use of the terms
"discounting" and "present worth" have equivalent meaning because they
botli relate to reducing the value of assets or dollars.
The term "cct,.rh flovv" is used to re.fer to the net inflow or outflow of
zlstne), that occtrrs durirry a specified csyserating Ttcriod such as a month or
r"C0r.
- Operating Expenses
- Tax Costs
- Capital Costs
= Cash
Flow
1-t
The term "discounted cash flow" evolved from the fact that investors
most often handle the time value of money uging present value calculations
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tors that are relevant in all industries for the proper economic analysis of
investments.
Examples of the use of discounted cash flow analysis today are innumerable. Income and service producing project investments of all types are analyzed using discounted cash flow analysis. Investors in minerals, petroleum,
timber, real estate, manufacturing, leasing, etc., use discounted cash flow
analysis to determine the upper"limit that they could be willing to pay for
mineral rights, land or assets to generate projected negative and positive
cash flows over future years that yield a specified return on invested capital.
Major companies use discounted cash flow analysis to evaluate the economic value of other companies. In a simplified form, by evaluating the
value of individual properties and businesses that make up a company, the
overall company value may be considered to be the cumulative sum of the
value of individual properties or businesses that make up the cornpany. The
acquisition bids for companies in recent years are situations where discounted cash flow analysis by major investors has indicated the value of
companies to be considerably different than the value common stock shareholders had been placing on the companies utilizing net income approaches.
Sometimes the discounted cash flow analysis will give a higher indicated
value of a project or company than other evaluation approaches might give.
Sometimes the discounted cash flow value may be less. The advantage of
discounted cash flow analysis is that in all cases the assumptions on which
the analysis is based can be explicitly stated and understood by all. If you
do not like the input assumptions they can be changed to what you consider
more realistic. The non-discounted chsh flow, older econornic analysis
methods have various implicit assumptions built in
may or may not be
(orrect in different analysis situations and, therefore,$at
often lead to inccrr:ct
economic evaluations. In particular, the older evaluation techniqr.:es d:
not
properly account for the time value of money. This is the single most
inipor_
t:int consideration that has caused companies and investors in most in,Justries to shift to discounted cash flow analysis since the mid 1960,s.
The real utiiity of discounted cash flow analysis is that it puts all invest_
rnents on a common evaluation basis of handling the time value
of money
with compound interest rate of return. In all industries, we are concerned
rvith analyzing inflows of money (such as revenues and savings)
and outflows of money (such as operating costs, capital expenditures and income
tax costs). Discounted cash flow analysis enables investors to fairly
and
properly account for the magnitude and timing of these dollar value
consid_
erations regardless of the type of investmeirt.
Operating Cost
Capital
Thx Costs
Project cash
23456
170 200 230 260 290
-40 -50 -60 _70 _80
-30
_40
+l
-50
-60
-70
The negative cash flows incurred during years 0 and 1 will be paid off by
the positive cash flows in years 2 through 6, very much like loans of
$200
and $100 thousand today and one year from today respectively, would
be
paid off by mortgage payments in amounts equal to the positive cash
flow in
years 2 through 6. what after-tax discounted cash flow rate of return
(DCFROR) would an investor be receiving if he incurs the negative
cash
flows in years 0 and 1 to generate the positive cash flow from revenue in
,rui
rii;lHlirii}ilhif,
10
years 2 through 6? The compound interest rate that makes the present worth
positive cash flow plus the present worth negative cash flow equal to zero.is
the desired rate of return, compound interest rate, or DCFROR. using those
terms interchangeably. This value is 20.8Vo for this stream;of positive and
negative cash flows.
Net present value (NPV), is the cumulative present worth of positive and
negative investment cash flow using a specified discount rate to handle the
time value of money. In general, the discount rate represents the minimum
acceptable investment DCFROR. For this example a discount rate of l57a is
used. Positive net present value represents the present worth positive cash
flow that is above what is needed to cover the present worth negative cash
flow for the discount rate used. In other words, positive NPV represents additional costs that could be incurred in the year NPV is calculated, and allow the
project to still have a DCFROR equal to the discount rate. Remember that rate
of return (or DCFROR) is the discr:unt rate that makes NPV equal to zero. For
the l5Vo discount rate. the NPV for the above values is +$54.75 thousand.
This represents the additional negative cash flow that could be incurred in
year 0 (in addition to the -$200 thousand cash flow in year zero) and have the
project yield a 157o DCFROR.
Sensitivity analyses can be made to see how the acquisition cost of
$54.75 thousand is affected by changing the relative timing of when the
costs and revenues are to be incurred. First, instead of incurring the cumulative positive investment cash flow of $600 thousand over years 2 through 6,
assume the same cumulative positive cash flow will be realized over years 2
and 3 with +$280 thousand in year 2 and +$320 rhousand in year 3.
Project Cash Flow
+320
Year
For this case the DCFROR will increase to 37.1% and rhe NPV grows to
+$135.2 thousand. Accounting for the rime value of money, and realizing
positive cash flow much quicker, enhances the economics of a project significantly. Second, if we slow down the receipt of positive cumulative cash
flow of $600 thousand so that the cash flow is realized more slowly over
years 2 through 9 with +$55, +$60, +$65, +$70, +$75, +$85, +$90, and
+$100 thousand per year respecrively, what is the effect on the project economics?
Project Cash
Flow -200 -100 +55 +60 +65 +70 +75 +85 +90 +100
t2
l-
4'56789
11
Def'erring positive cash flow into the future drops the Npv to -$11.7
thousand and the DCFROR to l4vo. Both values indicate that the project
is
rate of return and, in f'act, ttie Npv inclicates that we would have to be paid
s11.7 thorrsancl to takr this project ancl receive a fsq, return on invested
ciipihl.
Suinmary of Findings
lnvestment Life
3 Years
6 Years
9 Years
DCFROR
37Vo
ZtVa
I4Vo
+$135.2 +$ 54.7 _$ 11.7
Cumulative +CF, Thousands $600.0 $600.0 $600.0
Cumulative -CF,'Ihousands $300.0 $300.0 $300.0
Project
ProjectNPV @ 157o
In this example we have looked at three different evaluations o1. the same
cumulative negative cash flow (investment dollars) of $j00 thousand and
cumulative positive cash flow of $600 thousand. If we neglect rhe tin.)e
value of money, we would consistently determine that the project yieliis
$300 thousand in profits. Yet the economic conclusions that aicount fbr the
tiine value of money indicate a rarlge of Npv's for these three cases ftom
-S11.7 thousand to +$135.2 thousand. Obviously, project economics properly accounting for the time value of money can be very sensitive to the relative timing of investment capital costs and revenues over the expected proj-
ect 1ife.
The discount rate selected can arso have a very significant effect on economic evaluation results. To illustrate this concept we will analyze the Npv
of the six year life analysis for discount rates of l0 and 20 perbent, as well
as l5 percent. The results are presented below:
Discount Rate
NPV
107o
+$1 I 6.1
157o
207o
+$
54.8
+$
6.8
count rate.
12
It is widely
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13
2. Financial Analysis
3. Intangible Analysis
Economic analysis involves evaluation of the relative rnerits of investment situations fiom a profit and cost (or economic) viewpoint. Financial
anal\,sis refers to where the investment funds for proposed investments will
be obtained. Some alternate methods of financing investments include use
of personal or corporate funds. borrowing from a bank, having a corporate
funded debt offering of bonds or debentures, or going to the pubric with a
new common stock offering. Intangible analysis involves consideration of
factors that affect investments but which cannot be quantified easily in economic terms. Ty'pical intangible factors are legal and safety considerations,
public opinion or goodwill, political considerations in foreign ventures, ecological and environmental factors, uncertain regulatory or tax law conditions, and many others.
often times an alternative that looks best economically may be rejected
for financial or intangible reasons. For instance, attractive projects may have
to be rejected for financial reasons if internal funds are not available to
finance the projects and outside financing cannot be obtained at attractive
interest rates. Intangible factors that may cause rejection of economically
sound projects are innumerable, but high on the list of importance are
potential public opinion and legal problems from possible air, land, or water
pollution. The importance of financial and intangible analysis factors in
relation to economic factors must never be underestimated in management
investment decision making. They often are as important as economic considerations.
'14
L-
CHAPTER 2
15
15
2,2
This section presents the derivation of the six basic compound interest
formulas commonly needed to apply engineering economy @cision methorJs for proper comparison of investment alternatives. To develop general
formulas, the following letter symbols will be used throughout the remainder of this text:
AAAAA
..... . n-1
the
The interest
horizontal line. At time zero, "P" designates a present single sum of money;
'A" designates a uniform series of equal payments at each compounding
period; urd "F" designates a future sum of money at the end of period "n"'
it usually is desirable to put the monetary numbers from economic evaluation problems on this type of time diagram to reduce confusion that creeps
into problem statement; before attempting to calculate the desired quantities. Once the given monetary values are determined, it is necessary to
17
of time
calculations.
and,A",
as
follows:
Calculated
Quantir),
F
F
P
P
A
A
Given
=
=PX
Quantity
Appropriate
F/Pi.n
=Ax
=FX
=Ax
=FX
=Px
Factor
F/A;,n
PFi,,
P/A1,,
AFi,n
Mi,n
,,F,,,
factor sl,mbolism given here ctnd used throughout tr.te text is based on
.first letter in each fa.ctor desigriating the quan"tity that the
factor calcu_
lates, while the second retter designot"i the quantrty
that is girrr. The two
subscripts on eachfactor are the period intirest
rate, ,,i,,, ioilorrra bt,the
number of interest compounding period.s, "n".
rJse of this ,v*u"iirnates the confusion of trying to memorize
the name of each factor and "iir"i
when
to use each. For the student initiaily learning
time value of money calcuia_
tions, this is a great help in becoming familiar
with the apptication of com_
pound interest formulas. However, the
common names of the different fac_
tors should be learned eventually since riterature
commonlf us", ,u,r,"
terminology rather than symbolism.
There are only three basic types of time varue
of money calcurations:
.(1) calculation of future varue, "F", from
either ..p,, or ,,,q-ie) calculation
of uniform and equal period values, .A,,, from either ,,F,,
or .ip,,; (3) calcu_
lation of present value, "p", from eitirer ,.F,, or ,A',.
All time value of
money calculations invorve writing an equation
or equations to calculate
the
18
either
SINGI,EPAYMENTCoMPOUND-AMoUNTFACTOR.Whena
futnre value, "F", "n" periods frOm nOw, is tO be CalCulated ffom a present
the calcusum of money, "P", With cOmpOunded interest At"'i%o" per period,
lations are made as shown on the time diagram inFigure2-2'
Principal
Interest
f,
P(1+i)n
F = P(1+i)n
F=
2-l
P(l+i)n
The mathematical expression (l+i)n is called the "single payment comand is designated as F/Pi,n because a future single
pound-amount
factor"
-sum
,,F",
is to be calculatedfroru a present single sum of money,
of money,
,,P" at a given interest rate "i" for a git,en nuntber of compouttding periods
"n ". Example 2-I illustrates the use of the F/Pi,n factor'
Calculate the future worth that $1,000 today will have six years
{rom now if interest is 10% per year compounded annually'
Solution:
1.7716
P=$1,000
2.............6
F = $1 ,000(F/P10%,0) = $1 ,771.6
The F/Pi
,.,
P=F[1/(1+i)o]
r'
z_z
Solution:
P=
0.564s
$'1 ,000(P/F10%,6) = $SG4.S0
F = 91,000
series of equal investments are encountered frequently in economic evaluation problems, and it often is necessary to calculate the future worth, .,F,,, of
these payrnents. Derivation of the equation to do this follows. Each equal
20
tt
r
tll-0
n-1
A
periods
...
periods
A
n-2
period
n-l
F=?
F=A(1)+A(l+i)+A(1+i)2+...
+A(t+i;n-l
Z-3
2-1
F(1+i)-F=A(l+i)n-A
or
F=A
[(l+i)n-1]/i
2-5
calculate the future value forty years from now of a uniform series
of $2,000 Roth IRA investments made at the end of each year for the
next forty years if interest is 12/" per year compounded annually.
Solution:
21
money,
periods at
"i"
e*h
l-S;br'A".
A=F{il[(t+i)n_i]]
p".iod. for
,irir.
"" eqrr,i"^
2_6
the end
of each year for the next forty years that wourd jenerate
a
Solution:
...... A=?
F = $2,000.000
3.... -40 years
A=?
0.00'130
A = 2,000,000 (A/F1
2/",40) = 2,600
as flollows:
A = [P(l+i)n]til(l+i)n-ll = p[i(l+i)n]/[(l+i)n_l]
Z_7
The factor i(l+i)n/[(r+i)n-t] is calred
the "capitar-recoverl,factor,, ancr
,:_1r:::::,,rO,Ul *rr,o This
factor is used to catcutctte o unyonn series of
end oJ perod pa)'ments, "A", that are equit,alent
to a pr"seni single rum if
nxone)r, "P".
22
Solution:
P=
2,000,000
A=?
01
A=?
2
A=?..,....A=?
3.... .*..25 years
0.08581
A = 2,000,000 (NP7"y",25) = 171,620
A[(1+i)n-t]lli(l+l)nl
2-8
The factor [(1+i)n-1]/[i(1+i)n] is called the "uniform series presentvt'orth factor" and is designated by P/A;,rr. This factor is used to calculate
the present sum, "P", that is equivalent to a uniform series of equal end of
Mi,n = l/(P/Ai,n)
Solution:
A=91,000
P
A=91,000
=?
4.355
the six equat $1,000 values at periods one through six to time zero
(which is the beginning of period one), and not to time one, which is
assumed to be the end of Period one.
23
p-
'
gtve{i
'"l,rlr
n F=a(FlP'
U......
^.
---P=F(PiF;
trl-)
'
"
0...........
E
I
gtven
[(1
+i)n-1]/i
- FiA;,,1
F=A(FiA;,6)
A=F(A/F;,p) A
o'l .........n
tr
' gtven
Capital-Recovery Factor
= i(1,i)n/[(1+i)n-1] = tuPi,n
Pgiven A=P(A/P;,p)
P=A(P/A;,,1) Agiv,:n A
1...
1....n
*on"f
viewpoint
as
though a check u'as being received or written
at the end or each compound_
ing period. Such values are often referred
to as cliscrete ertd of period dollur
v'alues. However, not ail doilars are
actuaily realized at the end of a com_
pounding period. In addrtion to end
of period values, investors can also
work with beginning of period varues ani
nid-period varues. A fairly common xample of beginning of period values
might be lease payments. Usu_
ally, lease payments are made up front to
secure the use of the asset for the
made after the accrual of interest during each compounding period. When
invesrors are unqe-rlais as to the exasl-fi$jBg, or'.whg. n,,4ollars, rye l"r.9ly
flowing throughout a time period, it is common evaluation procedure to utilize the mid-period approach. As the name implies this approach literally
allocates dollars to the middle of each time period on a diagram. Each of
these different timing considerations are illustrated in the Example 2-7 .
p-2
$5oo
tr-2
0.7084
0.7722
0.8417
+4o0(P/Fgy",a\
+400(P/F9"/op)
+
400(P/Fg"/",2)
P = 300(P/Fgo/o,1)
0.9174
0.6499
+ 500(P/Fg "/o,S\= $1,529
or,
0.9174
2.531
0.9174
P/Fg
"/o,1)
0.6499
+ 500(P/F97., 5)
= $1,529
I
L--
For:mulas
.412
F = 300(F/Pgyo,q)
2i
.295
+ 400(F/p9 o/o,g)
i.090
+ 400(F/P9"/",1) + 500 =
.188
OO(F/pgo;21
$2,gS3
of,
1.412
3.278
1.090
F = 300(F/Pg"t",q) + 400(F/A9
V,g)(F/pg"y".1) + 500 = $2,353
OT,
1.5386
F = 1,529(FlPgy..S) = $2,359
equivalent annuar payments "A" can be carcurated
.ingThe
by spreadthe present
ments as follows:
0.2571
0.1671
P=?
0.8417
$500
0.7722
40}(ilrnr.rl
0.7084
+ 500(P/F97",4)
91,667
or,
2.531
0.7084
P = 300 + a00(P/A9"/o,g) +SOO(P/F9%,4)
= $1,667
PresentValueBasedonDiscreteMid'PeriodValues:
g
0.5
MathematicallY, P/Fi,n
0.9578
P=
2.5
1.5
3.5
$soo
;4.5
= Uh
0'8787
0'8062
400(P/F9"/",2.5)
300(P 1Fg"1",g.5) + 400(P/F9o/oj.5) +
0.6785
0.7396
+ 400(P/F9%,3.5) + 500(P/F9"/",4.s\ = $1,596
Note that the mid-period present value is about half way between
the beginning of period and end of period results'
Rates Based on
L-
27
i=rlm
An eft-ective interest rate is the interest rate tilat when applied once per
year to a principal sum wili give the same amount of interest equal to a
nominal rate of "r" percent per year compounded "r)" times per ye;r.
Arrnual Percentttge Yield (.APY) is the standard term used by the banking
industry to identify an effective interest rate. The development of the formula for an effective interest rate "8" follows.
Ihe future worth "F1" of "P" dollars invested ati%o per period for,.m',
periods is:
F1
=P(F/Pi,*)=P(1+i)m
2. . . . .. . . m periodsiyear
If an effective interest rate, "E", is applied once per year a future worth,
"F2", results from investing "P" dollars.
Fz=P(F/PE,1)=P(1+E)l
period/year
Since the initial principal, "P", is the same in each case, it is necessary to
set F1 = F2 to make the total annual interest the same for both cases. This
gives Equation 2-9 for "E".
(I+i)m-l
2-9
If an investor knows the effective interest rate but wants to determine the
equivalent period i value, compounded m times per year, Equation 2-9 can
be rearranged to solve for i as follows:
i=(1+E;l/m-1
So, if an investor wanted an annual effective interest rate of l2.OVa, but
the period interest rate.irvas to be compounded monthly, the relevant period
interest rare i = l.nll/12) - I =0.009489 orO.94|9vo per monrh.
28
lnterest
Rates
.*
Aninvestorisscheduledtoreceiveannualpayment$of$1,000at
years one, two, and three. For an annual interest rate of 10% compounded semi-annually, calculate the time zero present value and
ihe year three future value of these payments.
P=? 0 1
$t,ooo
2 3
$1,000
4 5
$1,000
F=?
6semi-annual periods
0.8227
o.gozo
0.7462
1.2155
F
1,000(F lP 5y",4)
1.1025
+ 1,000(F/P S"/",2) + 1,000 = $3,31 8
P=?
0
$1,ooo $1,ooo
$1,ooo
F=?
3annual periods
= 0.1025 or 1 0.25%
29
2.476
P = 1,000(P/A10.25,3) = 1,000[(1.10es;3
= $2,476
1yt(1.1025)3(0,1025)]
ot-,
0.9070
0.8227
o.7462
+ 1,000(P/F1 g .Zlo/o,Z't + 1,000(p/F 1 0.25"/o
B)
+
1,000(1/1
.1025)2+
1,000(1/1.1025)g
='1,000(1/1.1025)1
P = 1,000(P lF fi
.2g"/", 1 )
= $2,476
3.318
F = 1,000(F/P1
.21
55
.1025
Rates Based on
Continuous Compounding of Interest
If the number of compounding periods, "m", per year become very large
the period interest rate, which is the nominal interest rate, "r", divided by
"m", becomes very small. In the limit as "m" upproaches infinity, period
interest "i" approaches zero resulting in a continuous interest situation. with
continuous compounding of a nominal interest rale, "r", an infinitesimal
amount of period interest, "i", occurs an infinite number of times during the
evaluation period. This requires differential calculus derivation of continuous interest time value of money factors equivalent to the discrete compounding of interest factors developed earlier in this chapter. In Appendix B
factors are developed and illustrated for continuous interest and discrete
dollar values, while Appendix C factors are developed and illustrated for
continuous interest and continuously flowing dollar values. Following are
the continuous interest compound amount and present worth factors for discrete values from Appendix B.
30
.
etD
is equivalent to a nominal interest rate,"r", compounded continuously follows for a discrete initial investment of "p" dollars:
calculate the future worth, "F1", of "P" discrete dollars invested at a nominal discrete interest rate, "f" , compounded continuously for one year.
P
F1 = P(F/P.,1) = Pler(1)l
1y"*
Now calculate the future worth, "F2", of "P" discrete dollars invested at an
eftbctive discrete interest rate, "E", compounded discretely for one year.
F2 = P1F/PE,1.1 = P(1+E)1
;r year
Setting
Fl
E = er-1
2-10
ln(l+E)
31
creie interest rate of. l2.0vo, compounded annually, the present value is
s1(1/(l+.12))1 = $0.8929. The present value of $1 usinq a conrinuous
inreresr rare of ll.33vo is $1(r/e0.I133; = $0.g929. A6imilar equality must
ai:rr exist when comparing future values.
For investors u,orking with continuous interest, results (such as rate of
return) may be expressed as a continuously compounded nominal rate, or
converted to their effectir,e discrete equivaient annual value. Given that
most frnancial markets deal u,ith discrete interest, some investors working
with continuous find it easier to choose the later and compare numbers by
convefiing their continuous results to discrete values using Equation 2-10.
There really is no economic analysis advantage to rvorking with continuous
interest rates rather than discrete values for i. In fact, in many ways it simply
adds confusion to the analysis procedure. Continuous compounding is legai,
just not real cornmon in the t'inancial markets. Therefore, vast majorities of
econcmic evaluations are made using discrete compound interest. Finally,
Iinancial calculators and functions built into most spreadsheets today are
designed to work with discrete interest rates based on discrete dollar values.
This is just another advantage for utilizing the discrete methodology.
The effective interest rate, "E", described in Equation 2-10 is the discrete
interest rate that is economically equivalent to a nominal interest rate, ,.r",
compounded continuousl v.
To illustrate these tir,,o different types of interest rates, consider the l.5vo
monthly period interest charged on some credit card accouuts. This 1.57o
monthly period interest rate corresponds to a monthly compounded nominal
rate of 18.07o. using Equation 2-9, the effective annual interest rate that is
equivalent to a nominal rate of lBVo compounded rnonthly is E
=
(1+.0t5;12 - I = 0.1956 or r9.56vo per year on any unpaid balance. If the
I )1
32
(er-1)/r is the continuous interest, continuous flow of money, single payment compound amount factor for one period. It converts continuously
flowing funds to a discrete end-of-period ,urn. 1er(n-l); is the continuou.
interest, discrete dollar value single payment cornpound ameunt factor that
takes the end.of-period discrete sum forward to the end of period "n."
Continuous Interest, Single Continuous Payment
Present Worth Factor (P/T*1,n)
(P/F*r,n) = [(er-l)/r] [1/ (ern)]
(er-1)/r is the continuous interest, continuous flow of money single payment compound amount factor for one period. It converts continuously
flowing funds to a discrete end-of-period sum. 1i(em) is the continuous
interest discrete dollar value, single payment present worth factor that takes
the period "n" discrete sum back to period zero.
Equation 2-10 also results from considering a continuously flowing ,,p,,
dollar investment during year one as follows:
calculate the future value, "F" of "P" dollars invested uniformly during
year I at a nominal interest rate, "r," compounded continuously for one
year.
Ft = P[(er-1)/r]
Now calculate the future value, "F2," of the discrete present value equivalent of "P" dollars invested uniformly during year one at a nominal interest
rate "r" compounded continuously for one year. consider that the discrete
present value equivalent of the "P" dollars invested uniformly during year
one earns interest at an effective rate, "8," compounded discretely for one
year.
lnterest Calculations
Sotution:
A) P=?
F = $100
1........4
.6
0.4066
P = 100(PiF15%,6) = 100(1/e.15(6))
= $40.66
0.4724
P=
'F
c) P=?
1......4
= 9100
0.4386
P = 100(PiF"15%,6) = $43.86
D) P=?
1......4
5.5
0.4383
P = 100(P/Ft O.t8%,S.5) = $43.83
E) P=?
35
F=$50
0.l
F=$50
1........4
?
0.4724
0.4066
P = 50(PiF16.1B%,S) + 50(P/F16.18%,6) $43.95
=
iolution:
\) 8% Compounded Quarterly
) = $1,000
ll
1.608
2....24
F=$ 1, 000( Fi
2"/",24)=$1, 608
) * $1,000
1.543
2....6
ln Part A, the nominal rate of 8% divided by four quarterly comrounding periods gives us a period interest rate of 2.0"/", (available
n Appendix A). ln Part B, the7.5% interest rate is not in the tables.
[o solve this problem, substitute the values into the FlP7.5"y..6 factor
'ot
nathematical definition and solve that factor for an "i" value
7.5.k
0.075) and six compounding periods. This gives (1.07S;6 = 1.543.
\n alternative approach is to interpolate, as is illustrated below,
tsing the known Appendix A values of 7"/" and 87".
lnterpolation lor
F1P7.5"7o,6
'
37
FlP7.5oy",6:
587
= 1.501 + .5(1.587-1.501)
= 1.544
544
''a"
'_al
SC1
<.b+
<-C_+
Solution:
P = $1,ooo
$2,000/$1,000 =
F = $2,000 = $1 ,000(FlP
10"/o,n)
(F lP
g"7",n) = 2.O
Go into the 10% tables in the F/p;.p column of the 10% table for
F/P1g.7",n= 2.000. No factor listed giili:s exacily 2.000. Choosing the
closest values, linear interpolation between Fip19"7",7 1.g4g and
=
FIP 1g"7.,6 = 2.144 gives:
n = 7 years + (1)[(2.000-1 .949)t(2.144-1.949)] 7.26 years
=
A general rule of thumb that can be used to obtain the approximate period
of time required to double your money at a given
interest rate per
"o-pound
period. This rule often is called the Rule of 72 for an
obvious reason:
Number of Periods
to Double Money
72
Z_11
38
In Example 2-L1 note that 72110 gives 7.2 years needed to double your
money which is very close to the 7 -26 year result calculated. To double
money at 6Va interest per year takes 72t6 = 12 years, while to double money
at l2%o per year takes only six years. Approximation error [ecomes very
significant when dealing with three or less compounding periots, or interest
rates above 307o.
Solution:
P
$1,000
=?
1 2 3 4
$1,000
10
0.7903
0.6756
P = $1 ,000(P/F4"7,0) + $t ,OOO(PIF41",10) = 91,465.90
7)
$100 $100
1
2
$100
.60months
15o./o.
l'-
1......5
6......10
11 ..
..
15
tr-2
Solution:
Present Value
3.352
3.352 0.4972
3.352
0.2472
5.019 3.352
5.847
5.019
3.352
or
S,
O)
Future Value
6.742
6.742 2.011
6.742 4.046
F = 200(FlA1S,S) + 150(F/A15,sXF/p1S,S) + 100(F/A15,5)(F/p15,1
g)
8.137
= $6,'l 1 0 or, 751 (F/P15%,1S) = $6,1 1 0
Solution:
0.06903
A = $10,000(NFB/",10) = $690.30 A
=$690.30
F = $1o,ooo
iolution:
$3,ooo
$3,ooo
$3,000
0.30211
Payments
Annual
= $906'33 each
$3,000(A/FtOr,g)
Equivalent
=
of year three
the
end
at
years.
the
Spreading
$3,000
rear for nine
gives
equivalent
Same
the
rniformly ovei years one, two and three
lnnual cost as spreading the $3,000 at the end of year six uniformly
)ver years four, five and six. The argument is similar for ye"ars Seven,
>ight and nine.
13.579
Future Worth = $906.33(F/A167",9) = $12,308
1.331
1.772
ev = $3,000(FlP rc%p) + $3,000(F/P1 97",6) + $3,000 = $12,308
r.
41
Solution:
A=?
A=?
P = $10,000
A=
0.2638
$1 0,000(A/P1 0%,5) = 92,638/year
Figure 2-5 shows how these payments amortize, or pay off, the
mortgage:
END
OF
PRINCIPAL
MORTGAGE
OWED DURING
YEAR
PAYMENT
YEAR
1
2
3
4
$10,000
8,362
6,560
4,578
r,39q
--5
TOTALS
INTEREST AMOUNTAPPLIED
=.10
TO REDUCE
(PRTNCTPAL) PhtNCtPAL
NEW
PRINCIPAL
OWED
$2,638
2,638
2,638
2,638
$1,000
$1,638 $8,362
836
1,802
6,560
656
1,982
4,578
458
2,180
2,398
r!g__
__?fg9_ __
_____atgg__:::i_
$13,190 $3,190
$10,000
&
Periods
= (P)(iXn)
2-12
42
Solution:
lnterest Owed Each year:
Principal Owed Each year:
Total Annual payment
$1 0,000(0.'t 0) = $1,696
$10,000(0.20) = $2,996
$3,ooo
i
I
[n(n+l)] I 2
Z_13
'
I
I
I
I!
I
*
'l
..,
i$
$
$
$5,ooo
$10,000
these considerations.
Solution:
The mortgage payments are based on the 9100,000 loan value at
year over twenty years.
j
!
0.13388
A = $100,000(A/P 12/o,ZO) = g13,3BB per year payments
45
From the lender viewpoint, the actual net loan amount is:
$100,000 - $6,000 point fee = $94,000.
Net loan =
$94,000
Payments/year =
$13,39i9
$13,399
=0.14243
by interpolation:
NPISo/",20= 0.15976
NP12./",20 = 0.13388
i = 12/" + 3%[(0.14243 -0.13388)/(0.15976 -0.13388)] = 12.997"
12.99% is the interest rate actually being realized on the net loan
by the lender. lf the borrower is paying points, the borrower is paying
12.99"/" interest on the actual net loan amount. lf someone else is
paying the points, such as the seller of a house to be financed by an
FHA loan in the United States, then the borrower is really only paying
12/" annual interest.
The concept of buying down interest rates involves similar calculations. Consider a realtor who would like to buy down the interest rate
on $100,000 of twenty year loan money f rom 1 2h lo 10%. What upfront lump sum payment, similar to points in the previous calculations, will enable the lenderto loan $100,000 at 10% instead of 12"/"
with uniform and equal mortgage payments over twenty years?
Let X = buy-down payment at time of loan
0.13388
0.11746
($100,000 - XXfuP1 2"/o,20\ = $100,000(NPrcy",ZO)
o.11746
Actual Payments to be Received = $100,000(A/Prct",ZO) = $11,746
7.469
Required Buy-Down Payment = $100,000 - $11,746(P/A12/o,2e)
= $100,000 - $87,731 = $12,269
$12,269 is within round-off error accuracy of the previous method
rf explicitly solving for the payment which was $12,265. The $12,265
rp-front payment makes the lender net loan of $100,000 - $12,265 =
F87,735 dl 12"/" interest which enables the lender equivalently to
oan $100,000 allO% interest.
B
I
B+g
Z
B+2g
B+(n-2)g B+(n-1)g
The uni.forun serit.s of equol pa.\,rnents which is equivrtlent to an arithoJ payments may be found using Equation 2-r4: .
A=B*g(A/Gi.n)
rvhere A/G1,n =
2-14
various interesr rates, "i", and project lives, "n". The derivation of this factor
is presented in rire Appendix E. Example 2-21 ilrustrates the use of the
AlG1,n factor.
Note two things about the gradient series calculations. First, the gradient,
10
,1
3.871
g1 ,487.10
00 + $1OO(A/G6
"/",10) =
48
This result indicates that if money is valued al EP/" per period, the
uniform series of ten equal end of period payments of $1,487.10 is
exactly equivalent to the original gradient series, as the following diagram illustrates:
t
Solution:
6.508
grad. series
$2,900
F=?
57.27
$SOO
grad. series
-$1,700
Solution:
Conversion of the series of gradient terms to a uniform series of
equal payments from years three to fifteen yields;
Years 3
to 1 s: A = $s00+g10o,r"r;;:,s) = $eog.go
$969.9C
4........'15
Present Worth:
1.736
7.103
.8264
P = 500(P/A10"/",2) + 969.90(PlAlO"t",l3Xp/F1
O%,2) = $6,561
1.736
7.606
1.736
or = $Qg1plAlA"t",Z) + 969.90(PlAl1o/o,15 - p/A1
eo/o,2)
= g6,561
2.9 Alternative Time Line Diagram and the concept of cash Flow
An alternative time line diagram rhat often is used to more graphically
is allttcating ,ttt-
-f!ov's and inflox's o.f ntottet' ar rite poirtt in time clctsest to yvhen doilar
,trtttruxt.\ crre octuullv erpected Io be incurterl. when
we speak of inflows
lurd outfiorvs of money, on a befbre-tax basis, we are
referring to revenues
arrd capital or operating costs associated with a particular
inveltment. How_
e'cr, only if your projects are tax-free should you consider making
economic evaluations on a before-tax basis. In general, economic
evaluations
are made on an after-tax basis utilizing cash flow generated
from a project
fbr the investor's unique tax positron. In Chapters 2 through 6,
the dollar
value per period generated by adding revenue and capitar
oJoperating c,srs
in a time period should really be thought of as repiesenting positive
and
negative cash flow in that period. As mentionea in ihapt".
t]tt"r" first six
chapters ignore the specifics of tax considerations to ,"dr""
confusion while
gaining an important understanding of the basic concepts
of time value of
money. If we had a specified investment "p" at time zero
that was expected
to generate equal annual revenues 'A" over years one through
four, the
modified time line diagram may appear as follows:
&
50
+A +A +A
4^^i
+A
ltll
llll,-2-3-4
-P
Figure 2-7 Alternative Time Line Diagram Approach
EXAMPLE 2-24 lllustration of the Alternative Time Line Diagram
Solution:
+++
ttl
lll
i
-5,000
-10,000
Present Value @ 15h =
2.283
0.8696
0.8696
52
B) The future worth of the payments, i.e. the single end of year eight
payment thal would be gCgivalent to the given series,of paymenls.
C)The equivalent annual payments, i.e the uniform annual payments at the end of each year that would be eqqivalent.to the
given series of payments.
Solution:
$5,000 $2,000
glo,ooo
$2,500
2.913
gradient series
$5,500
0.4039
4.968
A)
B)
F=5,000(F/P
2.476
1
2.913
11
12.300
2,6)+[2,000+500(A/G 1 2,dl(F/A1
2,
0.0813
2.913
0.2013
C) A=5,000(A/P 1 2,g)+2,000+500(A/G 1 2,g)+1 0,000(A/F1 2,8) = $5,276
2.11 Summary
In this chapter, seven different time value of money factors have been introduced that incorporated a number of variables which are summarized below
in order of occurrence through the chapter, rather than alphabetically:
P
F
A
i
i+
n
m
r
=
=
=
=
=
=
=
E =
E =
(t+i)m-l
P/Fi,n
FPi,n
APi,,
.i
AFi,,
dGi,,
I
$
a value.
Calculates the series of uniform values at the end of each compounding period that is equivalent to a given present sum.
This
factor is most commonly used to calcuiate mortgage payments
when "compound interest,, is relevant.
calculates the series of uniform values at the end of each compounding period equivalent to a given future quantity.
calculates a uniform series of values equivalent to an increasing
or
decreasing arithmetic series of cash flows.
_ Finally, the timing of cash flows was another relevant issue in this chapter.
lt was emphasized that while most cash flow,s are considered to be discrete
end-<.rf-period
dlagram. The
54
PROBLEMS
.t
bond interest rates are 7.}Va compounded annually, wliat would you
need to invest in zero coupon (or deep discount) bonds today to cover
the estimated cost after 20 years? In other words, calculate the present
value "P" at time zero of $70,000,000 20 years from today for an
interest rate of 7.}Vo compounded annually. What uniform series of
payments at the end of periods I through 20 would also cover the year
20 cost? Use the same annual interest rate of 7.07o.
.ta
Calculate the present value, "P" at time zero and the corresponding
future value, "F" at the end of year three for a series of $15,000 payments to be made at the end of each of years one, two and three.
Assume that no payment is realized at time zero. Use a nominal interest rate
2-3
2-4
of
A)
B)
compounded annually.
2-5 Suppose you have a newbom child and want to begin covering the estimated cost of tuition and expenses for four years of college beginning l8
years from now Your estimated cost is $30,(n0 per vear beginning at the
end of year l8 and running throu-eh the end of year 2l (4 years). Assume
a nominal investment interest rate
.l
2-6
A)
B)
c)
: ,
"o*pornd"d
1)
2)
compounded monthly
for A and B and compare with the $20,000 cash
alternative.
compounded semi_annually
2-8 what
pounded semi-annually
2-9
is
of
com-
56
2-10 What monthly car mortgage payments for the next 36 months are
requirgd to ,amortize ra p{esent loan of $3,000 if interest is l2Vo compounded monthly?
2-13 A company can lease an asset for the next four years by making lease
payments that are equivalent to annual payments of $3,000 at year 0,
$6,000 at year 1, $7,000 at year 2, $7,000 atyear 3 and $4,000 at year
4. Use a lZ%o minimum discount rate determining the year 0 present
worth lease payments, yer 4 future worth lease payments and year 1
through 4 equivalent annual lease payments.
2-r4 An investor plans to invest $1,000 at the end of every year for 20 years
at lOvo interest compounded annually. what is the expected value of
this investment 20 years from now? What single sum of money
invested now at l0% compounded annually would generate the same
expected future worth?
I
A)
Determine the future value of all the payments at the end of five
years from now.
B)
What is the future value 5 years from now of the $2,000 plus
$1,000 annual payments if the 20Vo nominal interest rate is compounded semi-annually?
C) What semi-annual
each year
if
'j
i
I
i
l
D
f
I
ii
f,
'
B)
annually.
compounded annually.
C) what
2-19 calculate the present worth cost of service for the following cash flows.
The minimum rate of return is a nominal rl.ovo compoundid monthly.
BTCF
Years
Months
-8,000 -2,000
012
01224
-3,000
-2,500
a
36
&
s8
A)
Use monthly discrete periods and assume the l5To rate is compounded monthly.
B)
Use annual periods and assume the 15Vo annual discrete rate is
compounded annually. Put the payments into the analysis at the
closest year to which they are incurred. Compare this result with
the result obtained by handling the time value of money using the
effective annual interest rate of 16.07Vo that is equivalent to the
annual rate of l5%o compounded monthly.
C)
D)
2-24
7........
l0
rate, find:
A)
B)
2-25 Determine the sum of mcney that must be invested today at 9To interest compounded annually to give an investor annuity (annual income)
payments of $5,000 per year fbr l0 years starting 5 years from now.
2-26 Determine the monthly mortgage paymenrs that will pay off a $16,000
car loan with 36 equal end-of-month payments for:
A)
B)
'.-
llVo
59
t
2-28 C = Capital Cost, OC = Operating Cost, L Salvage
Value
=
All
C=$1,500
OC=$400
OC=$500
OC=$600
L=$300
A)
use 9.07o per year continuous interest and assume that dollar val_
ues flow continuousry during the year in which they are
incu*ed.
c)
60
2-30 An investor expects to realize annual revenues of $120 uniformly during years L,2 and 3. Calculate the present value of the revenue assuming a 127o nominal interest rate compounded annually. Assume the
revenues to
be:
uniformly during
years 1, 2 and3. Place the revenues at the closest discrete annual
point in time to which they occur by putting the month 1-6 revenue
at year 0, month 7-18 revenue at year 1, month 19-30 revenue at
year 2, and month 3l-36 revenue at year 3. This is the desired
approach for putting revenues and costs into analyses based on discrete compounding of interest with discrete annual end of period
values, such as most financial calculitor and spreadsheet analyses.
A)
of interest.
B)
C)
D)
Revenues flowing uniformly during each year are treated as discrete revenues at the closest annual period to which they are
incurred. In other words, revenues incurred within plus or minus 6
months of an annual period are treated as discrete sums at that
period. With this approach, put month l-6 revenue at time 0,
month 7-18 revenue at year l, month 19-30 revenue at year 2, and
month 31-36 revenue at year 3.
_l
f1
l
I
+)
61
&
,:
:
'
t.
loain arnoriizario;t-schedultr
I
2
3
4
5
Loan
Payment
Interest Rate
0.00
1,100.00
1,100.00
1,100.00
700.00
700.00
6.5Vo
6.5Va
7.0Vo
7.5Vo
7.5Vo
CHAPTER 3
3.1 Introduction
The five economic.decision method approaches in the
title of this chapter
are analyzed
I
in chapter 2, several examples and end-of-chapter problems relate to calr'i-ilating the present worth of a future stream of revenue for a given
interest
r';rte or desired rate of return. This calculation gives the initial
cost that can
he incurred for the future stream of revenue if you want to receive the
speci-
P=?
A)
p-2
34
l=$soo
l=9400
l=$300
l=$S00
l=$200
B)
4-
64
Solution:
0.8264
0.9091
1Oo/o,2)
0.7513
+ 400(P/F10o/o,3)
0.6830
+ 500(P/F1 0"h,4) = $1 ,071.76
1.381
3.170
oI, P4 = [200 + 100(A/G1 O%,4)1(PlA1O"/o,4) = $1,071 .78
1.274
2.589
i = 20o/o, P4 = [200 + 100(A/G2 g/",a)](PlA2O/o,4) = $847.64
Note that to get a 1oo/o rate of return you can afford lo pay $224
more than the $847 you would pay to gel a 20o/o rate of return.
1.381
i = 1Oh, P6 = [500
3.170
100(A/G1 g"/",a)l(PlA1O/o,4) ='$1 ,147.22
i = 2Oo/o, Pg = [500
1.274
2.589
Note that in Example 3-1, while you still pa"y more to get a70Vo rate of
return than to get a207o rate of return, the cost that you can incur for the "8"
stream of income for a given rate of return is greater than the corresponding
cost that you can incur for the'A" income stream. Since the cumulative revenue is identical for'A" and "B", the difference is due to the time value of
money. Getting the revenue more quickly in "8" enables us to economically
+'e
oJ.invest_
";;;;;rid
66
C=?
0
L=$25,000
0.3220
5.650
+
25,000(P
lF
C = PW Cost = 2,000(P/A1 z/",10)
p"1"1g) = $19,350
lf $19,350 is paid for the property at time zeto, a 12"/" rale of return
per year on the unamortized investment will be realized. lt is instructive to note the same result could have been obtained by writing a
future worth equation or an annual cost equation.
17.55
3.106
C(F/P1 2"/",10) = 2,000(F/A12,/o,19) + 25,000
C = [2,000(17.55) + 25,000]/ 3.106 = $19,350
4.1770
C(fuP1
z/"j1)
0.0570
= 2,000 + 25,000(fuF 12/",19) so C = $19,350
Solution:
C = Costs, I = lncome, L Salvage Value, i _ ?
=
t=$2,000
2 ........
10
L=$25,ooo
i)101
68
i=
Arithmetic Average
lncome
2,000
20,000
= 0.'10
i=?
i= 12"/o=2000(5.650)
= $20,000
+ 25,000(.3220) = g19,350
Because there are no 1 1% tables in Appendix A, we must interpolate between the 10% and 127o values:
i=10"/" +2%l(21,930
20,OOO)/(21,930
- 19,350)l = 11.5o/o
Present Value
$21,930
Rlght Side of
Present Worth
Equation
li
li
lr
li
-i-..i_,
lo.
I
l--."---.--.----...-..--.--..---- b
f
i:
BOR (i)
1 .So/o
"i"
Trial and error solution of this equation gives the same result: i =
11.5o/o.
The "i" value of 11.5% in this example is the rate of return per year
that the investor would receive on unamortized investment principal.
ln this text, rate of return often is referred to as "ROR". Other authors
sometimes use the term internal rate of return, or, "lRR", or, return
on investment, or "BOl", to refer to the same quantity. Whichever
term is adopted, it is helpful and important to note the exact analogy
between rate of return on investments in general, and rate of return
on mortgage investments or bank account deposits. ln each case the
ROR to the investor is calculated each year (or period) based on
unamortized investment, which is the investment value that remains
to be recovered. Project ROR is not the return received on initial
investment each period, it is the return received on unamortized
investment each period lt is very important to look at the unamortized investment values to which rates of return apply in using the
rate of return criterion for investment decision-making. A large rate of
return that relates to small unamortized investment value can have
very different meaning than a smaller rate of return that applies to a
larger unamortized investment value. That is why investments with
the largest rates of return often are not the best investments from an
economic viewpoint as is illustrated in Chapter 4.
The timing as well as the magnitude of costs and revenues that go into
discounted cash flow analysis criteria calculations is extremely important as
the following example illustrates.
:,
.t
Anarysis
z1
Solution:
C=Cost, l=lncome
Ar C=$1,000 l=$2,000
,.tnl
PW Equation: 1,000 = 2,0A0(plFi,1) 2,000(1/1 + i)
=
1,000(1+i) = 2,999
1,000 + 1,000(i) = 2,000
1,000(i) =2,000-1,OOO
i = ROR = 1.0 or 1OO%
o,
et
C=$1,000
l=$2,000
ROR=i=26.05"/o
-910.4)]
72
c)
c=91,000
0
PW Equation : 1,000 =
2 ., - 9' ,..
l=$2,000
.1,,-,,..,.
2,000(P/F;,5)
.Q., .r,,,,,.
- 1,000)/(1,134.8-
994.4)]
ROR=i=14.88'/"
The difference in these ROR results shows that the timing of doubling your money as well as the magnitude of the numbers is very
important in determining the economic analysis result.
'E.--,1
Cash Position
investor
$ext,
o1 the Jitncrs .froi, trt<, accoL.ltt (trte
itti,es.tLr
})ortion
rrrilrid,' positiv'e cash
flow). Ttu redttced aL.(.oitt1[ bcrance accrues irtter,st
Li
't;ittg tlte r.ext ce-tinpoundittg pe riod otrcl, evertiuatty the crtttbinatiott
,f
;'it(i{}.\'s
io
t1.itrrclrolt'_(i
pri,r,rip;;";;r;';;re
balance b
:i:ru ai tirc end of the project rife or sot'i,gs period.
The
folrowing
four
i''xarnples illustrate rate of return
calculation:i and provide an explanation
of
iireir meaning using
the cumulative cash position concept.
Solution:
writing an annuarworth equation as
we did in Exampre 2-17 gives:
10,000(A/Pi,5) = 2,63g, so i= 1O%
The carcuration of "i" wourd be by
triar and err.or if we had not
already determined the result in
Ex#ple Z_t Z.
-10,000
+2,638
+2,638
_2,000
cuM.
-4,000
CASH
POSrr. -6'000
_8,000
_10,000
il
:i
iil
{
$
?l
*
;{
1xo/o
74
Plotting the cumulative cash position for the 10% project rate of return
in Figure 3-2, we start out in a -$10,000 cash position at time zero. During each year we expect to receive d 1O"/o rate of return'onlunamortized
Solution:
lntuitively you can determine the rate of return in your head when
initial cost and final Salvage value are equal with uniformly equal revenues each period. Regardless of the physical investment, you can
always think of this analysis situation as being equlvalent to putting
the investment dollars in the bank at an interest rate equal to the project rate of return, withdrawing the interest each period, (which is
equivalent to the period revenue), and wilhdrawing the investment
'9.i
2,638
-2,000
cut/.
-4,000
cASH
POSIT.
-6,ooo
-8,000
-10,000
-12,000
-12,638
26.3go/o
76
'
Solution:
= $10,000
I = $16,105
PW Equation:
= 16,105(P/Fi,5), so P/Fi,5 = 0.62093
i = 10/" per year, by trial and error
10,OOO
-10,000
05
-13,310
-14,641
-16,105
chapter 3: Present, Annuar and Future Varue, Rate of Return and Break-even
Anarysis
on"Lo"t
Solution:
C=$10,000 C=$S,000
l=$9,000
l=$9,500
[=$9,500
l=$9,500
PW Eq:
1O,0OO
Rearranged Format:
3 = -10,000
DIV Eq: @
-'l 0,000
i=
5,000(P/Fi,1)
* 9,000(p/F;,2)
+ 9,500(p/Ai,3)(piF;,2)
30%:
oWEq: @i=40"/":
-1 0,000
3y interpolation:
= ROR = 30% + (40%
30%)t(1,687
triiminating interpolation
error by interpolating over smaller ranges of
than 30% to 40% gives gs.2s4% as the coirect'RoR resurt.
'-
78
-5,000 +9,000
+9,500
+9,500
+9,500
Cumulative
Cash
Position
-10,000
Continuous lnterest
For the cash flows presented below calculate rate of return for the
following assumptions regarding the type of compounding and flow
of funds in a project.
CF=j1__9f-13
012
CF=+19
345
A) Assume discrete end of period dollar values and discrete compounding of interest.
B) Assume a continuous flow of dollar values with continuous
compounding of interest.
C) Relate the solutions from (A) & (B) to show that they are equivalent and interchangeable.
Solution:
A) Discrete End of Period Cash Flows,
With Discrete Compounding of lnterest
PW Eq: '19(P/Fi,5) + 15(P/Fi,4) + 1a(P/F;,3) + 1B{p/Fi,2)
+ 13(P/F;,1)- 21 = 0
Anarysis
zg
1B(.444a)
Oy[9.06
- (-2.87)]] = 60.37o
0129456
CF=a19
c definition of p/F*r,n
PW Eq @
O)
t[2.2 B
(-1 .22)]]
46.9"/o
Compounding Results
-.*-
80
E = s0.464
= .5g04 ot sg.o4o/o
'ar:: The equivalence of the discreie'ano ioniinuous interest rate
of
return results is demonstrated. once you have either
result (discrete
or continuous), you can calculate the other using Eq. 2-10.
1
Value From
C = Investment
L = Salvage Value
(C
Cosr
It may not be immediately evident that Equations 3lent so the proof follows. Working only with Equation
3-z
(C-LXA/pi,n)+Li
= C(fuPi,n) + L(i
= C(A/Pi,n) +
- A/pi,p)
L{i - [i(1
- i) -
L(A/F1,n)
Anarysis
g1
-3-2 is very useful occurs when salvage value equars the initial
investment.
writing the annual value equation foiExampre 3-6 in the
form of Equation
.: 2 I ieiii:; lhe ann,-ial w'orth equation shown:
i.'icmEr
0
A\1' Eq' (10,000
- 10,000)(A/pi,5)
....
L=$10,000
+ 10,000i = $2.63g
Solution:
Using Equation S-1:
0.1 9925
A = 30,000(NP1S%,10)
0.04925
10,000(A/F1S%.10) = $5,485
82
3.5
Bond and debenture offerings are very popular ways for companies and
governments to raise debt capitai. Implicitly then, the analysis of bond and
debenture investments is an important investment anElysis for potential
investors. Bonds and debentures are similar debt paper except bonds are
backed by the assets of the issuing organization as collateral whereas debentures are only backed by the name and general credit of the issuing organization. These types of investments are really very straightforward to evaluate
but people often get confused between new bond interest rates (or rates of
return) and old or existing bond rates of return. Another factor that adds to
bond analysis confusion is that bond interest usurtlly is paid semi-annually
which means you must work with semi-annuul periods and a semi-annual
period rate of return to hcndle the time value of money properly in bond
yield calculations. Three other important factors to remember in bond evaluations are: (l) at the maturill\ date of a bond, the holder of the bond will
receive its face value as a salvnge or terminal value, (2) bond cost or value
will vary between the initial offering date and the maturity date as interest
rates fluctuate up and down in general money markets, and (3) Bond call
privileges are yvritten into most corporate or municipal bond offerings to
give bond issuers the right to pay ojf a bond issue early (before the maturity
date) at any date after the call date. Early payoff of bonds is desirable for
the bond issuer if interest rates have dropped significantly (by several percentage points) so the old bonds can be refinanced with new bonds at a lower
rate. Bcnd call privileges often affect the value of old bonds significantly, so
it is very important for potential purchasers of old bonds to account correctly
for bond call privileges.
U.S Treasury Notes and Bonds generally are considered to be the highest
quality investments available. They are semi-annual interest bearing obligations of the U.S Treasury, are issued in denominations from $1,000 to $1
million, and are unconditionally guaranteed by the U.S Government. Treasury Notes have maturities fiom two to ten years and are not callable by the
U.S. Government prior to maturity when they mature at face value. Treasury
Bonds are similar to Treasury Notes except that maturities are eleven to
thirty years. Some Treasury Bond issues are redeemable at par five years
prior to maturity and are known as term bonds. The U.S Treasury sells new
note and bond issues at various times, as money is needed, either to raise
new firnds to finance the Federal deficit, or to refinance existing bond or
note issues. A tax advantage associated with U.S. Government Securities is
ffi
;
ti
-lliapier 3; Present, Annual and Future Value. Rate of Return and Break-even Anarvsrs
tirat stat,: income tax does not hxve to be paid on interesr tiom U.S. Trea_
sury Bonds, Notes or Bills (see section 3.6 ibr Treasury BiII discussion;.
analysiJ
calculate the nelv bond rate of return for a new issue of $1,000
bcncs uriih a maturity date twenty years after the issuing cjate, if the
new bond pays interest of 940 every six month period.
Solution:
C = Cost, I = lnterest lncome (Semi-Annual), L Maturity Value
=
j
,t
C=
S1,000
l=$40
l=$40
l=$40
*
fr
If
*
T
The "i" value may be determined by triar and error. However, since
the initial cost is equal to the sarvage (or maiurity) value and period
income is uniform and equal; use the apprcxi;naiicn technique from
Exarnple 3-3 to explicitly solve for the raie of return.
ROR, i = 40/1,000 = 0.04, or 4.Oo/o par semi-annual period
84
Solution:
C = Cost, t = lnterest lncome (Semi-Annual), L = Maturity
C=$800
l=$40
l=940
2....
Value '#
l=$t0
L=$1,000
..28semi-annual
When initial cost does not equal salvage value there is no advantage in writing an annual worth equation over a present worth equation to calculate rate of return.
Present Worth Eq: 800 = 4O(PlAi,2g) + t,000(PiF;,26)
ln selecting the initial trial and error "i" value, remember that,,i" is a
semi-annual period rate of return. lf we paid 91,000 for the bond we
know i = 4'h, so try a higher value:
i = 6/"= 40(13.406) + 1000(.1956) = $Zgt.e+
i = 5"/"= 40(14.898) + 1000(.2551) = 9651.62
Solution:
(1) No early cail privireges, so use a'.14 yEai
(2g.semi-anndar
periods) life.
$1,200
l=$40
l=940
2.....
tir
varue
l=$40
...
..28
L=9.1,000
$1,200
l=g40
1=940
l=$40
L=91,000
i
ir
86
3.6
' u.s. Treasury Bills are short-term (beginning.in'2001, T:Bills are sold. as
either three month or six month instruments but in previous years 1 year
instruments were atsohvailable) obligations of the E.i ;;;;."*it"
offer investors a high quality return and minimal risk. Treasury bills are sold
at a discount so interest is received when the investor receives the maturity
value (or par value) back from the governrrrent. Treasury bills are sold in
denominations of $10,000, (or $5,000 increments above $10,000). Treasury
bill interest rates often exceed most bank certificates of deposit (cD,s).
Buying Treasury Bills at a discount effectively pays th; interest up-front
instead of at the maturity date of a Treasury Bill. This makes the T-bill
investment compound interest rate of return greater than the T-biil discount
rate, as the following example illustrates.
EXAMPLE 3-14 T-Bill Discount Rates and Rate qf Heturn
A $10,000, six month r-bill with a1o/o discount rate can be purchased. what is the equivalent compound interest rate of return on
this investment?
Solution:
T-bill discount rates are always given on an annual basis, so
!0% I 2 = 5.0"/" per 6 months. The 5% discount is realized when the
T-bill is purchased by 5% reduction in cost. The face value of the
Doubling this six month period rate gives an annual rate of return
vs
Anarysis gl
to
88
Solution:
l=$'15,000
= $100,000
l=$15,000
L=9100,000
l=$15,000
Marginal lnvestment
Flate of Return
Hypothetical
Budget Limit (X)
With Capital
Raiioning
Maximum Desirable
lnvestment ( Y)
With No Capital
Rationing
Opportunity Cost of
Capilal (OCC)Wlth Budget X
occ
Fcc
-TiT:1c"-:L9i
Capital (FCC)
Projects'l
234
($)
..................n
X
n+1
Anarysis
gg
*,"'"i;;ilil;;r,
of return of
20-0"/" would have to be rejected to
accept and finance the 1s.0olo RoR
project described. This creirry wourd
make suo.optirat use of investor
,"t"
;;;;;red
90
the last paragraph concerning opportunity cost of capital, when financial cost of capitatrs assumed to equal,,opportunity:cost of capitali
because capital is not rationed, it is assumed that financial cost of
capital will be the same in the future as it is todty. This is the basis
upon which many finance textbooks are written. lt is assumed there
that all projects with rate of return potential greater than the cost of
raising money (financial cost of capital) will be done. Financing often
is not as easy to obtain as it seems in textbooks. ln industry practice
capital usually is rationed, making the opportunity cost of capital a
bigger rate than financial cost of capital. To determine the opportunity
cost of capital requires evaluation of potential future investment
opportunities as well as today's investment opportunities.
As shown in Figure 3-6 for the $ymaximum desirable investment
level, opportunity cost of capital and financial cost of capital are
equal. For a budget in excess of gYthe financial cost of capital would
exceed the rate of return on the marginal investments so it would.not
be economically desirable to fund projects beyond tne $y budget
amount. lt is very important to note that although Figure 3-6 presents
projects in the order of decreasing rate of return, the reader must not
imply that rate of return is a valid project ranking technique. This is
emphasized and illustrated by example in chapter 4. project one is
not necessarily better economically then project two, just because
the rate of return for project one is bigger than the rate of return for
project two. All we can conclude from Figure 8-6 is that the cumutative investment of "$X" in projects one through four is better than
replacing any of these projects with projects five through "n.,' ln other
words, rate of return is an "accept or reject" criterion for each project,
relative to investing elsewhere, and not a valid method of ranking
projects. Also, when we say investing in projects one through four is
preferable to investing in any other projects, we are assuming projects
one through four are indicative of future investment opportunities (in
addition to today's opportunitiesl. Most investors make this assumption, but sometimes changing projected future investment rate of
return from what it is today may make more sense. Just because an
investor has many high rate of return investment opportunities today
often does not mean that similar opportunities will exist in the future.
This requires changing the opportunity cost of capital with time by
reducing future opportunity cost of capital from what it is today, as
illustrated by Example 4-6 in Chapter 4.
.4.
Anarysis gl
analysis carcura_
that;:;fi#;i
i"i';'rirg
ll
i
$
fl
$
s
il
I
i
92
Cost of
Cost of
Equity:
14.\Vo x 0.60 =
8.40Vo
Debt: 9.0%o,x0.40 =
3.60Vo
Cupitul-- =
12.007o
Financial Cort of
i
Many variations occur in the financiar cost of capitar calcurations
done
by dffirent cornpanies and investors. For exampre, income
generaily
tax
must be taken into account for valid analysis so you need.
to work with afteitax debt rates, risk-free investment rates and risl adjustment
rates. Also, the
risk adjustment rate can be attained with varying m.agnitude
using financiar
datafor dffirent historical periods. The riskfree rate-can be based
on short_
term u.s. Treasury Bills or intermediate term u.s. Treasury
Notes instead of
bonds. Debt-to'equity ratios can be based on current
market value of
common stock and debt rather than historical book value
of outstanding
debt and equits,^ securities. Ail of these variations generally
cause change in
the financial cost of capital results making it obvious
thai it is an estimate
rather than a precise number. Finally, many people have
begun to question
the validity of beta to measure the relative risk of returns
uu-uiluut". In fact,
in a June 1, 1992, edition of Fortune Magazine, Eugene Fama,
and Kenneth
R' French of rhe university of chicago declared, "beta is bogus,,,
and
therefore, not capable of telling investors much about investment
return
potential. Beta was designed to measure a correlation
in risk return in the
stock of one company, rerative to an industry or the
market. It was never
designed to account for the risk often associated with project
evaluations
such as political, environmental, engineering, marketing^or
geotogical risk,
which is the fbcus of this text.
As previously mentioned, for many companies the financial
cost of capital
is the basis for determining the company's minimum
rate of return, i*. However, it is equally important to recognize that in many
of these cornpanies;
even though they may utilize a discount rate of say,
L2.Tvo,projects earning a
12-07a return are rarery accepted. Instead the
company imposes a ..h*idle
rate" (a higher rneasure of performance, say rg.TEoi foi
alr projects. Hurdle
rates indirectly recog,ize that the company is not
willing to accept projects
that are just earning the weighteo aveiage financial cost-of
capital. instead
the company demands a higher return foithe budget
dollars rationed ro rhem
for a given period of time (a hurdle rate). unfortunately, hurdie
rares are a
short cut to recognition of the true opportunity cost foi
an investor. Hurdle
rates may not properly account for all relevant time
varue of money considerations. This can only be consistently achieved by using
a discount rate that
reflects the investor's perceived long-term opportunity
cost of capitar.
3'8
of
eutstion
of
EXAIUPLE
3-I6
Solution
Zero Coupon
Bond
= gl,0cc
10.063
2....30
F = $1,ooo(F/p67,39)
= $10,063
C=$1,000
L=$'1,000
I
I
164.494
F = $80(F/At oz,go) + $1 ,000 = $14,1 59
irllllr=
$.r,7s2
0.0573
10.0% lnterest: year 0 Vatue 10;063
=
{p/F1g.7.,g0)
= $5Oz
This is a 40.57," reduction in value.
0.0151
15.0% lnterest: Year 0 Value j0,063(p
/FlSj,e,gd= g.152
=
This is a84.B9L reduction in value.
This is a 2Z.Sohincrease ,,
l,ogglrr?l!l,lr.
,otrzltulrlSol
;rlr'J:'u
0.0573
9.427
i0.0% lnterest: Year 0 Value 1,000(p/F10%,30) g0(p/A10%,SO)
=
+
',
;,lu"l'
0.0151
6.566
15.0% lnterest: Year 0 Value 1,000(p/F1S%,gO) gO(p/A-15
=
./"SO)
+
This is
46.0"/"reducrion ,,
;,lu.1o
96
Notice that both conventional and zero coupon bond market values
are very sensitive to interest rate .changes, but zero coupon mar[gt
,.,.,*
values are much mors sensitive ihan conventional bonds.'Due'iii '''E
interest rate changes, investors in honds and deQentures can make ..,.+
or lose money just as fast due to market interest rate changes as
investorscanmakeorlosemoneyincommonstockorrealestate
of
An evaluation situation that involves partial reinvestment of revenue meaning associated with rate of return is in analyses involving effective interest
rates. Calculation of effective interest rates for either discrete or continuous
compounding of interest explicitly assumes accrued interest (revenue) will be
reinvested at the period interest rate during the effective interest rate period.
However, this reinvestment assumption only applies during the effective interest rate period which is usually one year and does not apply between periods.
If you make a 10 year life project analysis using annual periods with costs and
revenues each yearly period and calculate the project RoR to be z0.0vo compounded annually, this 20.0vo RoR is an effective annual interest rate. Reinvestment of annual revenues from year to year is not implicitly or explicitly
tied into the 20.0vo RoR meaning, but during any year money is considered
to grow (be reinvested internally) at the minimum rate of return.
Solution:
Cost =
$100,000
Rev =
$37,185
Rev = $37,185
'f're ratu'of
ni,rl,rr,rutenr of year
r,ytnr 25vo rate of
ot:e ti;roughJit'e'erurn
re,enues at 2svo tied into trte rneattirtg
Figure 3-7.
98
CF
'5
CUMULATIVE
-37,185
CASH
POSITION
-90,730
-100,000
-109,769
-125,000
/o
RoR project
It can be seen by analyzing Figure 3-7 that the 25vo RoR applies to
remaining investment value to be paid off (amortized) each year and that
interest from reinvestment of revenues at any rate of return is not related to
the diagram in any way. only if an investor is interested in calculating the
rate of growth of investment dollars does reinvestment of revenues affect the
calculations and meaning of rate of return results. This relates to the concept
of grorvth rate of return that is introrjuced and illustrated in the next section.
3.9 Growth
Rate of Return
Solution:
C = Cost, R = Revenue, F Future
Terminal Value
=
1_
R = $37,185
........5
C=$37,185..C=$37,1g5
Revenue Reinvest
Qt i* =
R = $37,.1gS.
6.353
where Future Terminal Value, F
= $37, 1gS(F/\2%,5)
F=$236,236
100
Total
C = $100,000
lnitial+Reinvest
0'
't
........5
F=$236,236,.
:i,:,::::J:,:3,i:l1r
:iil:)"ii,,i,"#_
:,Ti*"ili:,lH,illlr"::".""t".;;";",,;;;fi;#,-il;:J';::
j,1;
;T:JX':,::,:"i:ll.:1'"::::::-:1""::yll;ffi
t#
33 :::- ::":Y "'; ;'";;; ;, ;ffifi;' :':','iil ff#; li
H:Tl-i::."""1":i,gr:1y*"!,",;;;Hi.#;r:IJ[HI t or
i1:::
the meaning of
projeclRoR
costs,
i C;;;;6i.
-100,000
+236,236
E
CUMULATIVE
CASH
POSITION
-100,000
-1 18,760
-141 ,039
-167,498
-198,921
_236,236
il;i;t,,"ir.":"ii',i
Anarysis
10.1
i.7i,'i.
tite
projr;i
is
Gro,.r.ril R.OR.
C=55,000
PW Eq: 0 = -55,000
i = 25"/o: -55,000
C=45,000
I = 30,000
I = 30,000
.........10
4S,000(p/F;,1) + 30,000(p/A;,9)(p/F1,1)
102
C=30,000 C=30,000
B)
2 .........10
= 443,280
14.776
where Future Reinvestment Value, F = 30,000(F/A12y",g)
= 443,280
The overall groMh rate over ten years on the initial project "A" time
zero and year one investments of $55,000 and 945,000 respectively
can be found by combining the cost and revenue numbers on the project "A" and "B'time diagrams by adding them together. Combining project "A" with a 22.37"/o ROR and project "B" with a 12/o ROR must give
an ROR between 12"/" and22.37% on the combination of the projects.
A+B)
C=55,000
C=45,000
2..
..
10
= 443,280
i=
chapter 3: Present, Annual and Future Value, Rate of Return and Break-even Analysis
103
follows:
0.8929
Modified PW Eq: 0 = -55,000
45,000(p/Fi*=12/o,t) + 44Z,2gO(p/F;,16)
or 0 = -95,1 80 + 443,280(p/F;,1 g)
By trial and error, i = Growth ROR
16.2"/"
in using Growth RCR to rank independent income-producing alternaiives, it is necessary to use Growth RoR results based on the maxinrum caprial exposure in a project. This is not always the present
worth of all negative cash flows but is described in more detail begin_
ning in Example 3-21 and Section 3.11 of this chapter.
Finally, this modification of Growth RoR is similar to the procedures employed in some spreadsheet models. The Excel function
known as Modified lnternal Rate of Return (MIRR) is always determined from a single investment at time zero growing to a single
future value at the end of a project.
3.10 Net Present Value, Net Annual Value and
Net Future Value Methods of Analysis
't04
(NAV)
i*
i*
Cash Flow @
i*
i*
Flow @ i*
A positive net value indicates a satisfactory investment relative to investing clsewhere at the minimum RoR, i*. To illustrate the application of Npv,
NAV and NFV to evaluate projects consider the following example.
C = 55,000
C = 45,000
I = 30,000
I = 30,000
.2 ..........10
0.8929
0.17698
Analvsis
5.328
OO,OO0(P/A
0.17698
10S
0.8929
p,9)pF.rr,-;,,
?
3.106
3.106
or
3.106
= -55,000(F/P1 ZjO)
= +$147,665
2.773
-
14.776
4S,OOO(F/P12,9) + 30,000(F/A12,9)
F=443,280
14.776
where F = 30,000
(F I
A12,$ = 44B,2gO
4.32197
5.3283 0.89286
30,000(piA12,9)(p
iF1Z,1) = $O
This indicates a break-even with investing elsewhere at i- 1z.o"h
=
NPVg = 443,280(P/F12,19)
0.1 7698
NAVB = NPVg(tuP
12,10) = (0)(tup12,10) = gC
A+B)
C=55,000 C=45,000
F=443,280
2_10
0.32197
ot = 443,280(P/F1
= +$47,544 >
2. 1 O)
0.89286
4S,OOO(P/F12,1)
_55,000
106
The $3 difference in this NPV result and the initial project NpV is
due to factor round-off error:
:
or
'i
0.17698
0.17698
= NPVA+S(A/P12,1O) = +47,544(NP12,19) = +$8,414
ot = Qy',J,280
= +$1
_-,45,000
47,665
(F lP
p,g) -
55,000(
F lP
1 g)
for rate of retum analysis, is a major advantage of net value analysis. The
time value of money is accounted for properly and analogously by both rate
of return and net value analysis. The meaning of the minimum ROR, "i*", is
identical for both rate of return and net value analysis as well as all other
valid discounted cash flow methods of analysis. Net value analysis provides
a quick, easy and therefore very useful way of screening mutually exclusive
aiternatives to determine which is best as discussed in detail in Chapter 4.
Finally, remem.ber that a project earning a rate of return equal to the mininrunr ROR, "i'", has a zero net value, so projects with a positive net value
are better than investing money elsewhere at "i*".
An imporfant consideration to be aware of when applying NAV or NFV to analyze unequal life income-producing altematives is that a corrrmon evaluation life
must be used for all altematives. Normally the li{'e of the longest life alternative is
selected but any corrrmon life may be used. If unequal lives are used for different
alternatives, the time verlue of money considerations are different in annual value
and future value calculations and the wrong altemative may appear as being best.
This means that NFV must be calculated at the same future point in time for all
alternatives, or NAV must be calculated by spreading costs and revenues over the
sarne number of years for all altematives. Analysis related to comparison of
unequal life income-producing altematives is presented in Chapter 4.
107
AcqCost=? C=1,700
l=200
l=225
| = 2,250
5
0.7972
1,
700 ( P/F
0.7118 0.6355
0.5674
e%,2) + 2OO(p / F p/o S) + zzs(p / F e:;,1 + Z,2SO{p /F p1,s)
= +$206.758
Trlr!:
0.7972
0.7118
0.6355
1,700(P/F12/",2) + 200(p/F1
+
225(p/F12/",4)
2o/o1)
0.5674
+2,250(P/F12%,5) $O
=
-206.7
108
Using the cumulative NPV diagram makes it easier to determine the cash
flows that need to be included in the denominator in order to develop ratios
that rvill yield economicaily consistent results.
109
$olution:
of Fteturn (ROB)
100,000
; : -2,., t;;;,
P
100,000
;,,,:,..::llQl,il!t:
rojec-t,Lif e, (Ye.a'is)
l.
.
-100,000
:1531718
-178,06s
-239,006
-286,580
.l
-a--
2g.1o/o
110
lio/o
0.8696
-
-120,000
2.8550 0.8696
(P/\SV,yXPIF1
So/o,1)
= $67,389
To generate the necessary data points for the Cumulative NpV Diagram, an alternative approach is presented that yields the same NpV.
4
NPV After Year 5
NPV After Year
=
=
12,622
O7,gBg
50,000
o
a
(,
(L
I
-50,000
o
(U
-100,000
-150,000
,l'l
-200,000
l,.f
Project Year
ai^rd
111
follows:
0.57''8
3 Years of Cash Flow + (99,504/100,000 (piF15"L,4))
= 3"2 years
lf t.e cash frows were considered discrete end-of-period
varues, the
period r"ouid be rounded up and descrioed
u,
i.o-yuar
payback.
Discounted payback is a measure of financiar risk
" cimmonty
com_
puted with other economic measures such as rate
of return and net
Fresen! value. ln this case, it measures the time required r",
tni ii'_
counted cash frows to sum to zero. see section g.2 in
chapter o tor
more detairs on payback and the different ways it
might be determined.
112
it :
:.:tB
;:
roo,ooo
a
o
5o,ooo
. .',."I
25?:tF
r.. : .1t:it,t
r'
'. .:J;r,r".f
a:.
,,
-,
;
e'
.:
., . :.
i;l .lft-<inlrisnii: :"-.'
': 1:i.: r 'ir...r '
Discount Rate,
I'
3.ll
lPresentwo@
i*
ing elsewhere a[ "i*". B/C Ratio is also sometimes ref'erred t^o profitabilas
iq' Index, or; "P1," or Discounted profitctbility Index, ,,Dp\.,,
The numerator, "Present Worth positive Cash Flow @ ix,,, is
the
present worth of positive cash flow not required to pay
off future negative
cash flows. The denominator, "present wortr\ Negaitve
cash Frow @ i*,,,
represents the absolute or positive value of present worth
negative cash
Anarysis
113
i*
lP."sert
Efficiertct,;accuratery
reflecting the meaning of rhe
calcur"ri;; ;; pvR is u *Luru.. of
th" pr"r"rt
worth profit (Npv) being generur"a
p., p..r"r, worth investment doilar
as
describecl earrier. It is arsolwonr,
,otilg ["." tt,ut the denominators of both
B/C Ratio and pVR are the
same.
114
lPresentwo@
PVR
IPW Negative CF @ i*
or,
PVR =
PW+CF@i*
lFw - cF @l{
lpw-cF @ ixl
- lP-wlcF
@ t.T
or,
115
C=100 Rev=59
Rev=50
50 Rev - 50
3.......10
Rev =
EL tt'v
nn
o)
!50
)
o=0
-50
-
100
"8i-
116
Case 2
C=100
C=90
Rev=50
Rev =
50
Rev
='50
Rev =
50
4.772 .8696
.8696
B/C Ratio = 50(P/At g"1",g)(PlF1S%,i11100 + 40(p/FtSZ,t)l
= 1.5394 > 1, so satisfactory
4.772 .8696
PVR = [50(P/A157",9)(P/F1 So/",i
.8696
a}Q,Flyo/o,1)
.8696
- 100il100 + 40(P/FrsZ,r)l
= 0.5394 > 0, so satisfactory
100
zo.
ou
(E
E
E
o=
-so
-1
00
-1
50
l-t 00 -
15"/o
0.8696
4O(p/F 115/",1) | = 1 35
It doesn't make any difference whether the year one net negative
cash flow (-40) is derived from a cost (-g0) and income (s0), or if its
just an investment of (-a0). The same cumulative NpV position of
-135 is realized either way.
,.:$
_ C=100 Rev=59
Case 3
C=190
- 50
'
Rev
Rev --
Anarysis
S0
+.
112
Fiev = 56
....10
f;,'C Raiio:
4.487 .7s61
.8695
.8696
_ SO](P/F1
+
Ap/FtS,/",1)
S%,2)/t100 [1
S%J)]
= 1.444 > 1, so marginally satisfactory
= SO(PiAtS%,8)(Pirt
PVR:
5.019
= [50(P/A1
5,
0)
.7561
i 90(p tF t 5,2)- -r 0oy{1 00 +
.8696
fi a}p/i1sJ
.8696
_
) s0](p/F1 s j )}
20
7
10
-20
-40
zoo
-60
-'100
-80
E
f -120
-140
-1
60
-1
80
0.8696
l-roo - (140(p/F
1so/o,1) + so)(
0.8696
p/;;;;,1)l
= 162
1S"k
118
Case 4
C=100
01
C=90
Rev = 59
Rev = 59
Rev
50
Rev
- 50
3.......10
;
4.487
.8696
B/C Ratio = S0(PiAt
S,gXp/Ft S,e) - 40(p/Ft S,e; + SOle/15,1 ;
.7561
.7561
100
1.829
>
1,
so
satisfactory
=
4.487
.7561
PVR = 50(P/At
S,eXP/Ft S,Z)
40
.7561
.8696
(p/F 1g,2) + S0(p/F15
1)
- 100
100
80
60
iqo
z
o2o
(Ev
7tr
-zo
-qo
-60
-80
-1
00
-Maximum
15"/"
Note that the year two net cost of $40 is offset by positive
cash flow in
year one and does not cause more capital to be
at risk to the investor.
,.,gi
chapier 3: Present, Annual and Future varue, Rate of Beturn and Break-even Analysis
119
2-8
Gross Revenue
- Royalty Costs
- Operating Costs
- Capital Costs
Before-Tax Cash Flow
-200
-200
333
s56
-33
-56
-200
-350
-250
-320
180
0.8696
4.160 0.8696
NPV = -200 - 250(PlF15,1) + 180(P/A1
5,7)etF15,1) =.+$233.8
$233.8 > 0, so project economics are satisfactory.
P;-cjeci FOR is the "i" vaiue that makes NpV O
=
0 = -200 - 250(P/F;,1 ) + 1 80(PiA;,7)(p/F;,1 )
By trial and error with interpolation:
i = ROR = 29.6"/" > i* = 157o, so the project is satisfactory
PVR
NPV @ i-
tr-
233.8
PW +CF @ i.
lrw -cr o
i.
_
I
s"t".ilp lF rcx,i
= 1.56
200 + 250(PlF67,,l
1Bo(P I Al
120
Note that PVR + 1 = B/C Ratio. Also note that all four evaluation
criteria give the same economic conclusi9n oI very satisfactory
economics compared with investing etsewnere at a 15;/";;i;;f
return.
PVR results always give correct economic
Ftow
2-7
Before-Tax Cash
_20
-2OO
The cumulative cash frow is ih"
as for Exampre B-23 except
the final $320 negative net cash flow is delayed one year
to year nine.
0.8696
NPV
3.784
0.8696
0.3269
- -200 - 250(P/F.15,1) + i80(piA15,6)(p/F1S, j) + 500(p/F15,6)
0.2843
- 320(P/F1S,9) = +247.4
L'napter
i:
present, Annuar
and Future varue, Rate of Return and
Break-even Anarysis
Correct PVR =
121
247.4
= +0.59
+
[200 250(P/F15,1)]
I = j.Sg or:
= +1.59
example that means incruding the"uripresent varue of the year nine negative cash frow in the ratio deiominatti.
1",i. gives tne tottowing pvn:
lncorrect PVR
=--
247.4
t20t;2s0(p/Fj
. szqell 5pf
= +0.49
122
C=20
l=6
l=6
1..........5
C=36
l=6
'1
PW Eq: 0
l=6
..........5
3.791
NPV = -36 + 6(P/A1 O/",5) = -$13.25
cirapter 3: Present. Annual and Future Value, Rate of Return and Break-even
Analysis
1zs
c=$20
l=$6
l=$6
1....
...10
G.1t 4
+
6(PiA10%,10)
-20
= +$i6.86
lv=Jb
0
FVt' Eq: 0 =
l=6
...10
l=b
1....
6.144
NPV = -36 + 6(P/A10%,10) = +$0.84
The effect on RoR and Npv results from doubling the evaluation life
rom 5 to 10 years has been very significant for both cases. when the
evaluation life is less than i0 years, changing the life used has a very
significant effect on evaluation results for both economically good and
rnarginal projects. Now double the evaiuation life from 10 to 2o years:
f
C=2A
l=6
1....
l=6
...20
C=36
l=6
1....
l=6
...20
124
--
(29'5
(31 .08
- 16.86) x 100
16.86
=+84o/"
(15.9-10.6)x100
10.6
(15'08
=+507"
0'86) x 100
=ffi=+1,6537o
Anarysis
125
in
differ_
ind-ustries. The peroreum industry
especiarly tends to use unique terminol_
r'sr''
c,r
.orr,
*"
unrtogou,
to rand and
i ,tient acquisition cosis in general industr--y anai1,.ses. Research
t; ies are cquivalent to exproratioir
costs ilrcurred in searching for petroreum
and
r"incrllis' Project developnient costs
in aii non-rnining/ petroleum inclustries
are
:;irir llenl to deveroprnent costs in petrole*m
and minirg pro.jects.
irt,,n;ll'i;d;:
up front.
tr'lining can be segmented into se'eral
different categories including hard
rrck' coar, and aggregates. For each of these
categories, mine designs can
L'e based on open pit, undergrorrncr.
or a combination of both depending
on
thc ore Lrody. site rc'rcation, enl,iron,,ental.
and other intangibre issues. Hard
rocii nrinin-q includes gold. sil'er, read.
,i,.,.. .opp"r, molybrJenum, bauxite
anrl a variety of otherprecious. strategic
and non-strategic minerals. Due
to
the vertical nature of these industries,-mine
economics may go substantially
bc-r'ond the mine itserf
include miiling and smerting considerations
.to
as
ri'ell as transportation issues
that impaci the ability of a mine to turn
a
profit. In addition to those paramerers
ihat affect alr project economics such
as product price, other key parameters
in hard rock eJonomic evaluations
include ore grades, metallurgical recoverv
rates, etc. In.most hard rock min_
126
as
r;;;;."
Anarysis
127
-;il[r"r,"'
l=4.05
L=1.0
OC=3.00
cRecl=o'5
l=V.763 l=g 315
-CD"r,, =2.0 CDev=1.50
i=1A.246
ci,i'n.Rts=i.o
0
CEo
CC=5.400
=3.00
lr',irn.Rlg=i
OC=S.832 OC=6.298
_--<.
ear
BTCF
-3.0
_3.45
23
+2.363
+3.483
+4.448
=
r'50,000 tons/yr x 0.1ozr,ton x
0.g recovery x g300/oz g4.65p11y
=
Year 2 Revenue at the year
1 Selling price:
250,000 tons/yr x 0.1o2lton x
0.g recovery x g30O/oz 66.751,414
=
of
1so/o
in year z,2ao/o in
$9.31SMM
x 1.10 = $10.246MM
Operating Costs.
Year 1 j50,000 tons/yr x
$2Olton = $g.00MM
Year 2 Operating Cost at the year
1 Cost Rate
250,000 tons/yr x $2olton
= $S.000MM
Year 2 Operating Cost
= $S.O0O x 1.0g = $5.400MM
Year 3 Operating Cost
= $5.400 x 1.08 = $5.g32MM
Year 4 Operating Cost
= $5.g32 x 1.0g = $6.29gMM
128
NPV @ 15% using the beforetax net cash flows on the time diagram.
-3.9 -,3,45{P1F15,1 ) + 2.8ffi(P/F1 5;d,
+ 3.4$(P/F15,d + a.M\(PlFg.d = +$0.6e0
costs (the costs for tubing, producing equipment, tank batteries, separators
and
gathering pipelines necessary to "complete" bringing a well into production.
The acronym "IDC" often is used to refer to "intangible drilling costs,' in
petroleum drilling Fojects. Thx deduction considerations are the primary
differences in tangible and intangible well costs as discussed in detail for different
types of investors in Chapters 7 and 8.
when considering oil and gas investment opportunities, most fall into one of
four general categories. First, you can evaluate the project from the viewpoint
of the party holding all rights to the properry, which might be considered as
"development economics," or drilring a property "heads up.',
Both terms imply
that the intent is to look at all rer,'enue and costs as pertinent to the investor.s
economics. Second, you, the investor might consider passing the rights to
develop on to a second party who wourd put up all or part or thl drithng costs
and well completion costs. Typically the developer gets all or most of the
revenues until the costs are recovered and then you back-in at that future point
in
time for a working interest in the property. This is sornetimes referred to as
"famring out" a property. Third. you could also look at the opposite viewpoint
of a "larm-out" and consider developing a property that someone else owns for
an interest in the property. This often is referred to as "farming in,, a property.
The "farm-in" party is on the opposite sicre of a petroleum development agreement as the "fann-out" party. Finally, you could consider selling a property
and keeping a royalty, with no liability towards development of the p.op"rty.
This sometimes is referred to as retaining a "carried interest,' or an ..overriding
royalty'' in a properly
..i ialrier 3:
129
The rbi.rowing
viewpoint,
of
capitar
and
i';:craiiitg expendiiures paid by
the investor inl'ulved in
.,f-arm-out,,
'"{;in-in" evaruiition.i.
or
'a{ous
These ;green-,.rr, .rn bc r,-ery
aynrrii.'or,"r
a
propeny
iitc. ill,w'ing for i,terests in costs
an,.l revenues to change at
vanous points in
iire p;'uject rif'e as introduceci
in the cjerirition of some otit,,e iottor"ing
terms:
these terms herp to estabrish
royarties rc ue paia and the portion
Lr
.
riehis)'-'io,t
:J,:lr;lilJr$:r|i*'
r,.rared,op.ou"iffi
"#il;i:,:;.,ff
,HH:ffi I#J]
J;:-,"fl i,f
:rs l/Sth (125%) of grr;ss..u.r.r.,
or rhe weilhead varue of the
I{'r'aliies are usuailr' the rrrst e.\pense
i"
il
interests, etc. As
mentioned earlier, those net revenues
that are available often are referred
to as
a "ne[ revenue interest." ceneraily.
*ortJ,g inrerests ,turo ira.-p"ndent of the
re\enue ir)terest in a lease. Again,
, na,'a*nue interest can be defined as rev_
ettue lcrss royalties, overriding
royalties, carried interests, etc. This
is a frac_
lional intcrest based on the gts
,"r.rue potential from a lease. Net revenue
rLrpresents the dolrars available
to the invJstor to recover dollars invested
to
cover the working interest costs
to extract the lease resources (driling
costs,
lelrse costs, operating costs,
etc.).
130
sible for their share of applicable severance and excise taxes. These taxes
usuaily are paid directly b-y the operator. The operator then recovers the
appropriate prorated portion of these taxes by reducing royalties paid by the
prorated tax amount.
In many deals, the interest in the property may change as the property is
developed. This relates to reversion(ary) interests which represent the portion of the working interest that reverts or is allocated to another party after
a specified occurence, such as payout of investments by specified criteria.
:.-r*r
cnapter 3: Present, Annual and Future Value, Rate of Return and Break-even
Analysis
131
80
20
4520105
21 22 23
50
55
900
300
200
Year012345
60
65
24
70
12345
Year
Revenue
-Royalty Costs
-Operating Costs
-lntangibles(lDC's) -900
120
_19
_70
Bonus
31
= +$664.0
ROR = 43.5% is the "i" value that makes NpV = 0.
PVR = 664.0/1,400 = +0.474
NPV and PVR greater than zero and ROR greater than i*
= 12,/o
all consistently indicate economic acceptability of this project compared to investing elsewhere al a 12./" ROR.
132
: :.
t
$
:..
I
x
fl
133
B)
C=0
A-B)
='200
OC = -80- OC = -99 OC
= -1gg
OC=290
4
OC = 400
L=50
L=0
OC=-110
L=50
134
- 80(PiF1,1) -90(PtFi,2) -
1OO(p/Fi,g)
- 1 1O(p/Fi,g= 50(p/F1,4)
1OO(p/Fi,3) + 160(p/Fi,4)
-200
-220
-240
-260
-290
4
-300
B)
A-B)
-330
-200
-360
50
-400
4
80
90
100
110
50
."r"
,2)
+ 100(p/Fi,g) + 160(p/F;,4)
Itilq
135
., 30% = 16
.,4
4A"h =
-19
0.8333 0.6944
0.5787
0.4823
6O(p/F2g,4)
evalLraiion criteria.
0.7143 0.5102
0.9644
-200 + 80(P/F49,1)+ 90(P/FaO,2) + 100(p/F4g,3)
=
0.2603
+ 160(PlF49,4)
136
lncremental PVR
-18.8/2OO = -0.094 < 0, so rgect automated equipment.
t.
n
r
!
;i!
::,
,).
.:
},
:1
'I
chapter 3: Present, Annual and Future Value, Rate of Return and Break-even Analysis
137
-200
A)
-220
-240
-300
B)
-260
-290
-330
50
--400
-360
-200
0.6944
220(P /F 20, 1 )
24A(P
2g,2) -
4.5787
26Ap /F20, 3)
0.4823
24Q (P tF 2g,4)
0.6944
0.5787
330(P/F26,2)- 3G0(PlF29,g)
0.4823
4OA(?F26,4)
= -$880.4
- -880.4 = +64.2
Because the calculations are very similar, (both involve discounting at iJ some investors fail to recognize the difference in an incremental NPV analysis and an individual cost analysis of the available
alternatives. with a cost analysis the investor always wants to minimize cos.t, wnereas in NPV analyses, the objective is to maximize
value generated from savings or income from initial investments.
@ 2oo/o
0.38629
-816.2(A/P 20"h,4) = -$315.3, Least cost alternative is "A"
138
2lo/o
2.0736
-816.2(F/P 20"/",4) = -$1 ,692.5, Least cost alternative is
Future Cost (FCg) @ 2To/o
,,A,,
2.0736
-880.4(F/P ZO"/",4) = -$1 ,825.6
changing the minimum RoR to 4oy" trom 20"/o changes
the economic choice to rejecting the automated equipment
i,itn ail cost
analysis criteria, just as it changed the economic
choice with RoR,
NPV and PVR anarysis in the pievious exampre. present
worth cost
analysis is presented here.
0.7143
= -200 -220(P1F40,1)
40o/o
0.5102 0.3644
0.2603
= -$636.8
0.7143
= -300(P/F40,1)
40o/o
0.5102
330(P/F40,2)
a.9644 0.2603
- 360(p lF4s,s) - 4oo(ptF4g,.4)
,,8,,
_ pWCg, the
,j
139
tir
li
ti
i
{
fife income_
producing altematives, or.for comparing
service-producing projects thar do
not re sult in the same service. AssumptiJns
for the evatuatiin of unequal life
income-producing projecr,
-" p."r."ted and illustrated in chapter 4, whire
'ural1'sis of service arrernatives ihat provi,Je diff"**
;;;;e il ao.tresseo rn
Se ction 3. i 7.
To get a nreaningfur comparison of
unequal life artematives that provide
Ihe sanre service, assriinptio,s or
estimates must be made to permit compari'':oo of ihe alternatives on an equ:.rr rife or
equar study periocr basis. you are
contpar.ing diffc-rent tiitrrl sen,ice
il -you compare project costs tor unequal
tii'L'pci'iocis. Three
wi, be prese.ted rhat corer the possible *,,avs
of c.rnfarine u,equarir:.:l"dt
lir-e projects. Combinarions of these
*"ril;;';;r;i;
be used. The methods are not listed
i, their order of importance or varidity. It
is irnpossible to say that one method
is best for ail situaiions. project circum_
stances usually dictate the method
that is best for given evaluation condi_
lions' However, method 1 is seldom
a desirable or valid approach to use. you
should be familiar with it because
many textbook and literature authors ha',e
aili'ocated its use. Methocrs 2 ancr
3 are trrc approae.hes that in generar
sltould be used Io olttcrin a con.tmon
studt, period fbr unequat life projects
tlrttt prot'ide thet same sen'ite. The
three mlthods io. ot,trinrng a common
stud) r-'criod for urequai life service-producing
alternatives are described and
illustrated usin-q the fo,owing tlvo
unequal life alternatives .A,, and ..B,,.
C = Cost, OC = Operating Cost, L
= Salvage Value
o,
C,q
OCAI
OCA2
,A
140
Cg
u,'0
OCgl
|
OCBZ
2
OCg3,
rB
. This method of getting a common study period for unequar life arternatives is based on the
that pro;ects ,A,, and ,,B,,^can O"
.as.sylntion
in-kind for the same initial
costs, opeiating costs and salvage values until a
common study period equal to the lowest common
denominator between
the pro.iect lives is attained. For alternatives ,A,, and ,,B,,
replacement in_
kind gives a six year study period as follows:
r"r*;
A)
B)
Ca oCar
01
Cg
OCe2
2
OCnt ocgz
CA OCet OCRZ
C4 OCat OCn"
,LA-r--L4
t-A
A
3
4'6
oce: r
^ Ce oCgl oCnz oCg: J
LBm-LB
I.
ci
ani
Anarysis
141
Anorher
Thi.s method
tii'es is
A)
CA
OCat ocaz
2
,,,
La
oc'lll octsr .^
,
0
|
I .B
9L
a common study period for unequal rife artematives is based on extending the life of the
shorter life alternatives by estimat_
142
{p
o,, .;r,
")
B)
Cg
Lg
"apter
143
Alternatives
Cd000
Ar
OC1=1,599 OC2=2,996
L=1,000 ;
t]\
L=2,000
c;
-'
c=L
0
,}
soo
L=5,000
;;
C=6,000 OC=1,500
B)
C=3,000
OC=2,000
OC=2,500
L=1,000
C=14,000
OC=500
OC=600
OC=700
L=3,000
L=7,000
144
0.43798
0.907
0.28798
AC4 = 6000(A/P1 S"/",g) + 1500 + S00(A/G1
5/"p> 1000(A/F1 sy"S)
0.7561 0.43798
+ 3000(P/F 1 S%,2)(Np1
S%,g) = $5,287
ttvr:
0.43798
0.902
0.907
O.ZgZgg
ACg = 10,000(A/P 15"/"p) + 1000 + 400(fuG1
_ 3OOO(A/F
S"/",g)
15"/",g)
= $4,897
0.43798
0.907
0.28798
AC6 = '14,000(A/P 15"/",g) + SOO + 100(A/G1
7O0O(A/F1S%S)
So/oB)= $4,706
If different service-producing
{
{
!
I
I
{
chapter 3: Present, Annuar anci Future Vair-re, Rate of Return and Break-even
Anarysis
14s
a needed service for the next three years. lt is estin:dfed that irie salvage value of these machlnes will be zerc in three
,.ears and that they
will need to be replaced at year three wrin two n:,..r r-irachines that each
qive 1 50"h of the productivity per machine being r+alized
with each old
rrachine. The nelv machines r,vould cost 9145,0ii each at year three.
The service of the old and new machines is needed for the next five
vears. so use a five year evaluation life assuming the salvage value of
the new machines will be $50,000 per machine it year five. Operating
ccsts per machine for the old machines are estimaiec to be $30,000 i;
ycai one, $35,000 in year two, and 940,000 in year three. Operating
costs per new machine are estirnated to be g33.000 in year four and
$36,000 in year five. Another alternative is to buy ihe t*o n"u,
,'nachines now for a cost of 9125,000 per machine to provide the
neecjed service for the next five years with annual cperating costs per
machine of $25,000 in year one, g30,000 in year two, g3s,000 in year
three, $40,000 in year four, and $45,000 in year five. sarvage varue
at
year five would be $15,000 per machine. For a nrinimum Bon
of ts.r,.,
Lise present worth cost analysis to determine the most econornical
ailernative way of providing the needed service. Then cjetermine the
uniform and equal revenues for each alternative that would be required
at each of years one through five to cover the cost of service at the
15o." before-tax minimum ROR.
B) "2 New"
IT
C=135_
OC=72
L=1 00
C=250
L=30
146
0.7561
0.6575
0.8696
PW Cost4 = 135 + 90(P/F15o/oJ) + 105(P/F157" ,Z) + 410(P/F157"
0.5718
0.4972
+ 56(P/F1 S"/.,4) + Q2 - 100)(P/F1S7",S) = $586
$,
0.7561
0.6575
0.8696
PW Costg = 250 + 50(P/F1 S"/o,1) + 60(PiF1 S"/",2) +7O(P/F15"/oS)
0.5718
0.4972
+ 80(P/F1 5y",4) + (90-30)(PlF6"1o,g\ = $460, select min. cost
Alternative "8" with the minimum present worth cost is the economic choice.
rr
chapter 3, Present, Annual and Future value, Rate of Return and Break-even
Analysis
142
rncome is afiected
Solution:
1....
...._-l2,0oo
.....5
3.7908
PW Cost: -120,000
-. 2^-60,000
Att
0
PW Cost: -60,000
12,000(P1A1g"7",5) = -$165,490
-6,000.
1....
-
.._6,000
...15
7.6061
6,000(PiA rc%,15) = -$105,637, Select A2.
148
3.7908
NPV = -60,000
=
_959,953
.6,000
. 6.........15
6.14# 0.6209
3.18 Summary
several decision criteria were introduced in this chapter to help investors
evaluate a variety of different investments. Those methodologies and related
issues are summarized here along with the related acronyms.
1. Rate of Return, i
Rate of return, "i" is the compound interest rate received on the unpaid portion of the dollars invested over the project life. It is also defined as the compound interest rate that makes NPV equal zero. Solving for RoR involves a
trial and elror process and interpolation between the two interest rates that
bracket a present worth equation equal to zero. To illustrate the meaning of
"i" the cumulative cash Position Diagram was developed to show how this
measure of profitability is identical to the compound interest rate received in a
savings account. The RoR is compared with other returns from other perceived opportunities to determine if a project is economically acceptable.
149
uost of capital but rather, thc- expected cost oi capital over the period of time
Ior which cash flows will be discounted. Although not advocated, FCC is a
(lo;Irnoit t:irsis for determining a conlp.rn), mi;-,imurn rate of returlr.
i.,.
i*)
Hurdle Rates
bf
the fuiancial cost of capital ininimum rate of return do noi add value to a
portfolio but are a breakeven economically with those other perceived
opportunities. This approach is very common, but may lead to inconsistent
economic conclusions if compared to proper use of a discount rate based on
opportunity cost of capital.
5. Reinvestment l\Ieaning Related to ROR
N{any' analvsts and authors have been confused on the subject of the
irnplicd reinvestrnent nreaning associated r.vith RoR. There simply is no
;nrplied rc-investment meaning associated with intlividual project compound interest rates of return. However, if an investor or company wants
an
investment portfolio to grow over time at a given rate, then all projects now
and in the future must achieve that level of return to sustain the overall
"rate of grorvth."
150
NPV is defined as the sum of all cash flows discounted to a specific point
in time at the investor's minimum rate of retum, or discount rate, ix. NFv is
the measure of value created by investing in a project and not investing
money
elsewhere at the minimum rate of return. Npv greater than zero is acceptabll
compared to investing elsewhere at i*. An Npv equal to zero is a breakeven
with investing elsewhere while a negative Npv is unacceptable. The cumulative NPV Diagram illustrated graphicalry the value of one additional year of
cash flow and its impact on the overall project NpV. This diagram also
introduced the concept of discounted payback and maximum capital exposure,
which identified graphically the correct measure for denominators in ratios
such as Present value Ratio and Benefit cost Ratio summarized next.
Related "value" approaches include Net Annual value (sometimes
referred to as a Net uniform Series) and Net Future value. Like Npv, these
measures look a revenue minus costs but as described, on either an equivalent uniform series basis, or at some future point in time.
8. Present Value Ratio (pVR, Also known as
as;
ci
151
!
I
ii/c
with
calculations involve
capital-intensive airernative from an alternative requiring
a greater initial inr"estment, or simply, biggc-r initial
investment minus
sr,allcr. This difference should leave ilincrementai
diagram with an initial
cosi that generates c'per.ting co,;t sa\ings in future
uJo., to prcrvide the
tiesired rcturl on the up-f.ant in,,.estl,e*t. To properlr.
interpret
.ir the increniental cush florv strealn nru.st Lregin ,i,itl.,'u cost. For .v-our analy_
instance. if
,,io!l;1rq are not investerj up
front. there is no \\ay you can talk about rate of
r(riirrl r.ireariirs in your i'csults. This toprc will be amplificd
in chapter.l.
sirbtracting a
Lr.ss
1s2
PROBLEMS
3-1
of each year for the final 3 years of the 16 year life of the patent. If the
owner of this patent wants a lump sum settlement 3 years from now in
lieu of all 16 payments, at what price would he receive equivalent value
if his minimum rate of return is 87o before income taxes?
J-J
'A"
Machine
.ir
Analvsis
1s3
*:''l
'4,'
and
(.B,'.
y21xe
l-5
3,-6
A,
anr-,u^l
3'7
3-8
'alue
anarysis.
154
at time zero
aod $ 100 million ar the end of 2 years, from time zero with incomes of
$40
million per year at the end of years 1,2 and3 and incomes of $70 milrion
per year at the end of years 4 through l0 with zerotalvage value predicted
at the end of year 10. calculate the rate of return for thisproject.
3-10 Equipment is being leased from a dealer for $500,000 per year with
beginning of year payments and the lease expires three years from now.
It is estimated that a new lease for the succeeding four years on similar
new equipment will provide the same service and will cost
$750,000 per
year with beginning of year payments. The frst payment under the
new
lease occurs at the beginning of year four. The equlpment manufacturer
is offering to terminate the present lease today and to sell the lessee
new
equipment for $2 million now which together with a major repair
cost of
$600,000 at the end of year four shoulc provide the needed equipment
service for a total of seven years, after which, the salvage value is
estimated to be zero. use present worth cost analysis for a minimum rate
of
return of 20vo to determine if leasing or purchasing is economically.
the
best approach to provirJe the equipnrent sen.ice l'or tlie next se\.en years.
Verify your conclusion rvith ROR and NpV analysis.
3-l1A
erate profits of $90,000 per year starting at year two and .urnirg
through year 10 (a 9 year profit period) with projected sarvage value of
A)
B)
Determine the continuous interest rate of return for these discrete investments assuming all dollar values represent discrete
end of period funds.
c)
cnapter 3: Present, Annuar and Future Value, Rate of Beturn and Break-even
Anarysis
. D)
i'iorv r-rssinni,g from year r-2, to )'ear 9-10. Sarvage florvs from
1'ear
E)
ILi-li.
calculate the project rate of return assuming all dollar values after
ti*re zero are discrete values realized in the middle of each compounding period. Assume the time zero investment is a discrete
sum at that point.
A)
B)
verify your result from (A) with present worth cost analysis.
156
3-17
A 20
,i
chapter 3: Present, Annual and Future value, Rate of Feturn and Break-even Analvsis
157
l-lint: The eft-ecrive interest rate on a loan is based on the actual doilars
available to apply to the purchase of a home, etc. While effective rates
Iiom a savingr account viewpoint (see development of Equation 2-9)
measured the annuai rate that if compounded once per _v-.Ear, would accrue
lirc same interest as a nominal rate conipoitnded "m" times per yezr.
3-18 T\r'o developnrent alternatives exist to bring a new project into produciion. The first de..,elopment approach u'ould involr.e equipment and
de'elopment expenditures of $ I million ar year 0 and $2 million at year I
to generate incomes of $1.8 million per year and operating expenses of
S0.7 million per year starting in year I for each of years I through 10
r,"'hen the project is expected to terminate with zero salvage value. The
second development approach would involve equipment and developmenr expenditurcs of $l million at year 0 and experrses of $0.9 million at
year I to generate incomes of $2 miliion per year and operating expenses
of $0.9 million per year sta-rtirig in vear 2 for each of years 2 through l0
when the project is expected to terminate with zero salvage value. For a
minimum rate of reium of l5vo, evaluare which of the alternatives is econornically better using rate of return, net present value and present value
ratro analysis techniques.
3-
l9
mine the maxirnunr value of the company today considering the opportu-
nity cost of capital is 2A7o. The company assets are in two areas. First, an
existing production operation was developed by the company over the
past two years for equipment and development costs of $100,000 two
years ago, $200,000 one year ago and costs and revenues that cancelled
each other during the past year. It is projected that revenue minus operating expense net profits will be $ 120,000 per year at the end of each of the
next 12 years when production is expected to terminate with a zero salvage value. The second companv asset is a mineral property that is projected to be developed for a $350,000 future cost one year from now with
expected future profits of $150,000 per year srarting two years from now
and terminating l0 years from now with a zero salvage value.
158
3-20 Based on the data for a new process investment, calculate the before-tax
.. annual cash flow, ROR, NPV and PVR for a l5Vo minimum ROR. Then
calculate the break-even product price that, if received uniformly from
years 1 through 5, would give the project a157o invtutment ROR.
Cost dollars and production units are in thousands:
Year
Production, units
012345
62 53 35 24
t7
28.7
Equipment Cost
Patent Rights Cost
Operating Costs
750
250
670
100
256
3-21 Based on the following data for a petroleum project, calculate the
betbre tax annual cash flow, ROR, NPV and PVR for a l5Vo minimum
RoR. Then calculate the break-even crude oil price that, if received
uniformly from years I through 5, would give rhe project a l57o ROR.
Cost dollars and production units in thousands.
Year
Production, bbls
Price, $ per bbl
012345
62 53 35 24
t7
28.7
750
250
610
100
256
chapter'3: Present, Annual and Futurs. Value. Rate cf Returrr and pfeai(-ever
Analysis
't
59
3-22 The following clata relates to a mining project with increasing wasre
rock or overburden to ore or coal ratio as the mine life progresses, givirrg declining productirn per vear. calcuiate the before iax annuai
cash
flow, RoR. NPV and pvR for a 157o minimum I?oR. Then carculate
tlie break-eve n price per ton of ore or coal that. ia received uniformly
Irom years 1 through 5, rvould gir.e the pro,:ect a i5Zc ROR..
Cust 6s1iu.t and production are in thousancls.
Y'e;rr
62 53 35 24
Prcduction, lons
Selling Price, $/ton
17
28.7
Develcpment
Equipment
I,liling
750
250
57A
256
TT
160
3-24 Discount rates on U.S. treasury bills (T-Bills) are different from normal compound interest discount rates because T-Bills interest effectively'is paid at the time T-Bills are purcha.sed'Iather than.at the maturity date of the T:-Bills. Calculate the nominal annual rate of return
compounded semi-annually to be earned by invesfing in a 6-month
$10,000 T-Bill with a 5Vo annualdiscount rate.
3-25
l,
I
3-26 For a desired rate of return of 15Vo on invested capital, determine the
maximum cost that can be incurred today by an investor to acquire the
development rights to a new process that is expected to be developed
over the next two years for a $1.5 million cost at year 1 and a $2.0
million cost at year 2. Production profits are expected to start in year 3
and to be $1.0 million per year at each of years 3 through 10. A $3
million sale value is estimated to be realized at the end of year 10. If
the current owner of the development rights projects the same magnitude and timing of project costs and revenues but considers l07o to be
the appropriate minimum discount rate, how does changing the discount rate to l0o/o from 15Vo affect the valuation?
Lraptei'3: Present, Annual and Future Value, Rate of Reiurn and Break-even Analysis
161
zero.
Il
estimated to be
the oil and gas mineral rights are already owned b1. an investor
3-28 Your integrated oil and gas company ov/ns a l\CIvo working interest in
a lease. The iease cost is considered sunk an<i not relevant to this
before-tax analysis. if you elect to develop the ]ease for your current
87 .5vo net revenue interest, the following costs will be incurred.
In
vear zero, intangible drilling costs are estimated at S250.000 while
tangible completion costs at the same period are estimated to be
$100,000. For this examp.rie, neglect any potential sale value or abandonmenr costs at year 4. operating costs are estimated to remajn con_
\tant at s-I.00 per barrel (inclucies production costs, severance ancl ad
'"'iiiurer.ir raxes). oil prices are forecasred to be $20.00 per barrel at
lear J aiid 2 and then escariire 5.ovc per year in each of years 3 and 4.
Production is summarized in the table below. The escalated dollar
minimum rate of return ts 12.\vo. Use net present value, present value
ratio, and rate of return analysis to determine if development is economically viable.
Year
Lease Cost (Srrnk, Not Relevant To This Analysis)
Drilling
Intangible
$250,000
Thngible Completion $100,000
ProdLrction
(bbls/yr)
(g/bbl)
(g/bbl)
Selling Price
operaring cost
Royalty (12.5Vo Gross, or in
3.000
$22.05
$4.00
$2.756
162
3-29 Evaluate the economics of problem 3-2s it you were to farm out the
property described in that statement based on the following terms.
You would re ceive a 5 .OVo overriding royalty (5 .TVo of gross revenues)
untii the project pays out, Payout is based on un$scounted ,net revenues minus operating costs' to recover before-ta-x capital costs estimated at $350,000. Because of the additional overriding royalty, the
producer will realize a 82.5Vo net revenue interest to payout. For this
example, neglect any potential sale value or abandonment costs in year
4. Upon payout, your company would back in for a 25.07o working
interest and a27.875Vo net revenue interest (25.0Vo of 87.5Vo). After
payout the 5.lvo overriding royalty terminates.
3-30 A gas pipeline manager has determined that he will need a compressor
to satisfy gas cornpression requirements over the next five years or 60
3-31 A new $10,000, ten year life U.S. Treasury Bond pays annual dividends of $800 based on the 8.07o annual yield to maturity. (A) After
purchasing the bond, if interest rates instantly increased to !O.OVo, or
decreased to 6.0Vo, how would the bond value be affected? (B) If the
bond has a 30 year life instead of a ten year life, how do the interest
rate changes to l0.0%o or 6.0Vo affect the value? (C) If the 30 year
8.0Vo bond is a new $10,000 face value (yr 30 maturity value) zero
coupon bond instead of a conventional bond, how is value affected by
the interest rate changes?
Anaivsis
163
For a minimum rate of retum of 9.0% per year, should the current
system be retained or modified? use present worth cost analysis
and verify your results u,ith net present value analysis.
option 2
CHAPTER 4
op"iorio, o,
4'l
155
C=50
l=50
l=50
1...........5
L=50
c =l9Q
0
l=250
1...........s
L=500
166
B_A) C=450
l=200
l=200
1...........5
L=450
= RORB-
A=
44.4"/"
chapter 4:
r"4utuarry Excrusive
atC=$50
0
B) C = $500
l=$50
l=$50
I = $250
| = $250
1...........s
1...........5
L=$50
L = $500
't
68
A) c-=
$$q
I = $2oo
| = $2oo
1...........5
L = $450
.4922
3.352
S"/",5)
.14832
NAV4 = 50 + 50(A/F1
So/o,S)
S0 = +g1+ZISO
500 = +$5g6.60
.29832
50(A/p1S%,S) = +$42.50
NPV6-4 = NPVB
NPVA = 586.6
3.352
.4972
or = 2Qg1p I Al S"t",S) + 450(P lF
1 S"/",5)
directly from the incremental data:
142.5= +$444.10
4S0 = +$444. 1 0
.F
1.........5
Anarysis
169
,E^t-tn
\
a^^ . ^= 450(F/P I St",S) = +$904.95
0.4972
IJPV = 9C4.95(P/F15%.5)- 450 = $0
Similarll,, NAV
n) c
=l!Q
0
B) C = $500
l=$50
l=$50
1...........5
I = $250
I = $250
1...........5
L=$50
L = $500
170
B_A) C = $450
I = $200
I = $200
1...........5
L = $450
171
leni rvith NPV or ratio analvsis because time zero is a common point in
time for calculating Npv or ratios ot either equal or unequal life altematives. If you have unequal lives for different alremati,res, the tirne value of
molle)' consideratiofis are difi-erent in rate oi return. annual value and future
vaiLie calcuiirtiolts and you may chocrse the wrong aile5nslir. as being
best
if lt-ru do not get a coir.lulon evaluation lii'e. This merely meaus that
1-ou
inu51 calculate NFV at tlie same future point in tirne for aij alrematil,es. or
you inust calculate NAV by s;.readilig costs anci revenues over the same
nurnber of years for all alternadves. hr RoR, tret value or ratio anctbsis of
Lm.:quol life income-producirtg altenntit,rs, treat all projects as hat,irig
equ"al lives whk:h are equal to the longest life project with net reyenues
and
cosrs of zero in the later rears of shorter life projects. Note that this is not
the same technique presented in chapter 3 to convert unequal life sen,iceproducing alternatives that have revenues associated with thim, to equal life
aiternatives using either Method 1,2 or 3. when projects have different
stalting dates, net present value must be calculated at the same point in time
tbr all proiects tbr the results to be comparable.
172
(B) Develop
(C) Sell
-200:gl_100j00
150. . . . . . 150
23
10
200..
...200
150
10
Solution for i* =
15.07o:
NPV4 = -200
4........8
350(P/F1S,1) + 100(P/A1S,2XplF15,1)
10
ROR4
Anarysis
17g
= 13.1g%
<
A.
(B)
Develop
NPVB = -300
{9100 J00_!00
01
-
2oo.
. . . 200
400(P/F15,1) + 200(p/A15,9)(p/F15,1)
RORB
PVRg
= 182.0/
[3OO +
so, B is acceptable
All criteria indicate that Alternative ,'8,, is economically acceptable compared to investing money elsewhere with equivalent risk
at
i" = 15.07".
(C)
Sell
150
0
174
-450
NPVg-g = -450
400(P/F15,1) + 200(P/A15,9)(P/F15,1)
is satisfactory,
accept B.
or,
NPVB
NPVC = 182.0
175
HORg-g
15.A"/o, so,
accept B.
C.
176
$1,200
br,ooo
o
5
co
o
o
$8oo
\.- .'.
$6oo
. :.,.\]
$400
o-
zo)
$200
$o
10%;
($eool
Discount Rate, i*
lntersection points between the projects indicate the "i." values that make the
prgjects a break-even. They also indicate the incremental rates of return between
the respective alternatives. For example, RoRa-c is equal to 1s.gg% as previously
calcula.ted- Since selling is a time zero value, its NpV is unatfected by the discount
rate, with NPV remaining constant at $150 for all disccunr rates.
-300-400
(B) Develop
0
200..
...200
177
150
{C) Sell
1 2 3
Solution for i* = 15.0o/o:
NPVg = -300(P/Fr
S.e)
4...
...12
+
400(p/F15,3) + ZAOptA15,9)(p/F15,3)
NpV.
selecting the maximum Npv project "c" (or selling) is the economic choice. This is a different economic decision than was
reached for the project timing described in Example 4-2 where ,,8,,
Deveiop started at time zero with NpV of +192.0.
o 1 2T.-:z
PW EQ: 0 = -'150
.....200
PVRg-g = lncremental
=
=
NPV
/ lncremental PW Costs
When properly applied, NpV, ROR, GROR, pVR and B/C Ratio
criteria will lead to the same economic conclusion in the evaluation of
mutually exclusive alternatives. lf projects have different starting
dates, for valid NPV analysis of mutuaily exclusive alternatives, project NPV's must be calculated at the same point in time before
proper interpretation of the results can be ma'de.
178
An existing production facility must-be shut,down unless an environmental capital cost of $1so mittion is incurred now at year 0. This
improvement will enable production to continue ano @herhte estimated profits of $60 million per year for each of the next g years
when salvage value of the facility is projected to be zero. An alternative under consideration would combine process improvement and
expansion with an environmental cost change for a cost of $200 million now at year 0, plus $150 million cost at year 1 to generate estimated project profits of $00 million in year 1 and $120 million profit
per year in each of years 2 through 8. The minimum ROR is 12ol".
Evaluate which of these alternatives is better using ROR, NpV and
PVR analysis. Then, change the minimum ROR lo 2S/o and analyze
the alternatives using the same techniques.
61C=150 l=60
01
B)
l=60
C=200 C-150 l=120
l=120 l=120
l=120
.8
ROR Analysis
12o/o
12o/o
l=60
l=60
-A ) PW Eq: 50 = -'150(p/F;,1)
i = RORB-
179
l=60
4......8
+ 60(p/A
A= 2jo/o > i* =
i,Jyprci1
12o/o
So select "8".
- 150 = +$148.1
4.564 '0.8929
0.8929
NPVB
NPV4 =ZOg.7
PVRn=r+h=#=o.ee>o
PVR.L'=
NPVB
PW Costg
208.7
200 + 90(P/F1
2/o,i)
=0.74>0
180
Which alternative is better, "A" or "8"? "A't is not necessarily preferred just because it has the largest ratio on total investment. As
with ROR and NPV incremental analysis must be made and Present
Worth Cost "B-A" is taken from incremental "B-A" time $iagram and
does not equal Present Worth Cost B minus Present Worth Cost A
because of the effect of year 1 income on the year 1 total and incremental investment net costs.
NPVg-4
208.7 - 148.1
PVR3-4 =
PW Costg-4 50 + 150(P/F12/"J)
= o'33 >
t'
;L'*''ff1'ffi;",.::fitent
with the
See the incremental "B-A' time diagram for verification that the
incremental costs are 50 in year 0 and 150 in year 1 .
Benefit cost ratio analysis gives the same conclusions following the
PVR analysis procedure. Remember that benefit cost ratio equals
PVR plus one, and one is the break-even ratio with benefit cost ratio
analysis while zero is the break-even ratio with PVR analysis.
Change i* lo zso/o:
ROR Analysis
181
NPV Analysis.for i*
=21o/o
3.329
NPV4 = 6O(P/AZSy",A)
150 =
3.161
+$49.24 ,
0.8000
NPVg = 120(PlAZ57.,)(P/F2So/o,1)
0.8000
90(p/F25
"7",1)
2OO
= +$31.46
NPVg-4 = 31.46
- 49.74=
-18.28, so reject,,B,,
. Note that you cannot use the Npv results calculated for a 12o/o
discount rate to achieve valid economic conclusicns for a 2s% discount rate.
PVR Analysis for i* = 27r/o
PVR1 =
PVRg =
NPV4
PW
Cost4
NPVg
49.74
1S0
=.33>0
31.46
PWC"ttB=2@='25>o
PVRe-4=
pwc"ffi=ffiNPVg-4
31.46
49.74
,,8,'
= -.'1 0 < 0, so reject
NPV and incremental RoR and pVR indicate that alternative ,,A,, is
the correct investment choice when the minimum rate of return is2s"/".
Note that NPV and PVR must be recalculated at the appropriate
minimum RoR in order to make correct economic decisions. ln this example, NPV and PVR at i* 12/o cannot be used to evaluate
=
the alternatives when the minimum rate of return has changedro 25%.
&
182
4.3 Mutually
'
It
was mentioned in the summary of the Example 4.1 Res. analysis that
Grorvth RoR analysis is applied to evaluate mutually excluiive alternatives
in the same way regular RoR analysis is applied. This means calculating
Growth RoR on both total investments and incremental investments to verify that both are greater than the minimum ROR, ,,i*,,.
C=200
l=80
l=80
B)
C=300
l=150
L=140
Declining Gradient
L=200
L=0
183
Solution:
Both Growth
.r,.ilrtion.,
Alternative "A,,i
A) C =-?e9
l=80
0.1
l=80
L=200
1S"h
C=200
C=80
.8
C=80
F = 1,298
where F = B0(F/A
1b"/",g) + 200 = +1,29g
A + Reinvestment of lncome
C=200
F = 1,298
Alternative "8,':
B) C=-300 l=150
l=140
declininggradient,'L=0
- 15"/o
_____9= 1s0 C = 140 declining gradient
O
l----,.......8
where F =
['t S0
F=1,677
184
B + Reinvestment of lncome
C
=_t99_
F = 1,677
F=379
(B-n; c =
3.059
100
1...........8
= 100(F/P1S%.8)
= $305.90
Therefore, the total future value g years from now of $200 thou_
sand invested in project "A" and 9100 thousand elsewhere is g'1,2gg
thousand + $30S.9 thousand or g,|,604 thousand. This is not as
great as the future worth of "8" calculated to be g1,677 thousand, so
select "8". This is the same conclusion reached with Growth RoR
analysis. NPV analysis indicates select,,B,, as'follows:
Npv4
-200
Anarysis
1g5
2.781
4.4t7
10(A/c1s%,g)Xp/ArSZ.e) = +$248
,;;;;
(B.A)
C=
100 l-70
1
l=60.....1=0
2........8
L=
-200
4.{
o"i.i",
"riteria
if
you
186
B)
l=10
l=10
3.
.10
l=12
l=12
L=20
L=30
Anarysis
1g7
1i2o/oover
or
12.0o/o,
so satisfactory
12.O"/".
B-A)c19
l=2
l=2
!=2.-.'.-,-.-,-.-.'
3...........10
t=lo
i=
The investor cannot tell with rate of return analysis whether the
incremental "B-A" investment is satisfactory or not relative to investing
elsewhere at 30.0% over the next two years and at 12.O% over the following eight years. The fact that rate of return analysis of projects often
breaks down and cannot be used when discount rates that vary with
tirne possibly is one of the main reasons that changing the discount
rate with time is not more commonly applied in industry practice. A
large majority o{ companies emphasize rate of return analysis over the
other techniques of analysis and that cannot be done if discount rates
are changed with time. Notice that for a uniform minimum discount rate
of either Q.A"/o or 30.0% over all ten years, incremental rate of return
analysis gives economic conclusions consistent with NPV analysis
conclusions. Select "B" if i* = 12.0o/", select "A" if i* = 30.0%.
Finally, if firms are utilizing a discount rate based on financial cost
of capital, that number is very likely to be changing over project lives
the same as opportunity cost of capital changes. once again however, rather than trying to forecast those future changes, most companies use a financial cost of capital calculated today, aS reflecting the
average financial cost of capital over the project life. We do not advocate the use of financial cost of capital unless unlimited financing is
assumed to exist so that financial cost of capital equals opportunity
cost of capital. Remember that it is always opportunity cost of capital
that is relevant for valid discounted cash flow analysis of investments.
139
at
.futurc,
"i"')
i*orte-protrucing
"hhu
projects or incrcmental differences betw,een seruice-producing
pt-ojects usirtg
corn'entional cctslt flow' anarysis sigti ctstweniitrt t'herc
,rrt, i,i negadte and
t?t'i.turcs are positive, so the altenntit.e yielding nu:xilnrun
net v-altts is selecud.
To uiliize cost e*ralysis in rhe e'aluation of sirvicetroarcing
altematives, you
work with the given or estimated costs for each individual
alteriative way of pro_
viding a service. To utilize net value anaiysis in service evaluations,
you must
work with incremental savings that incremental costs will generate.
Net v'iue
analysis is just a short-cut form of rate of rerurn anelysis.
Foinet
or rate of
tetLlm attalyses, )'ou must look at the incremental
'alue
differences betwecn
altemative
rt ays of providing a se^,ice. The foliowing
exarnple illustrates these techniques.
EXAMPLE 4-Z A Comparison of present Worth
Cost and
Net present Value Analysis Criteria
0"
1"
2"
3"
Cost of Annual
Heat Loss (Per Year
$o
$ 60,000
$ 85,000
$1 18,000
$40,000
$20,000
$10,000
$ 6,000
190
Assume the insulation and project life are eight years with zero
salvage, valuq,,and.bgse your analysis resutts on.both present wsrth
cost analysis and net present value analysis. The 0"'option represents the current situation, so in calculating net presnt value, compare the current situation with the other amounts of insulation.
0" lnsulation
40,000(P/A12,g)
= g1gg,704
200,000
o 150,000
oo
o
100,000
=
o
a
o
o-
50,000
0 lnches
lnch
2 lnches
lnches of lnsulation
Figure 4-2 Present Worth Coit Analysis
3 lnches
191
1"--0"
2"-0"
3"-0"
20,000(P/A 12,8)
30,000(P/A12,S)
34,000(PiA12,B)
=$c
- 60,000 = $3g,352
- 85,000 = $64,028 * Maximum NpV
- 118,000 = $S0,ggg
* seleciing
two inches of insulation now maximizes the net present
vaiue obtainable from these investment alternatives.
This is illustraied in Figure 4-3.
70,000
60,000
:
;o
(E
50.000
40,000
30,0c0
zo,aoo
o.
10,0c0
0
0lnches
1 lnch
2 lnches
3 lnches
192
tives are compared with the current "do nothing,,scenario, the individual economics were determined. Next, the inih-by-inch incremental
analysis for each of these mutually excniriv"
Oras;;;:'
1o4'
20,000(P/A1e;A)
"it"iriiiiv.r'is
,, ---
60,000'E $39;B5Z
2'-1'
10,000(P/A12,g)
25,OOO =
g24,676
$gg,os2 = g24,676
comparing the next level of investment to the last satisfactory level
gives:
$64,028
3'-2'
4,000(P/A1 2,g)
- 93,000 = -$1g,1 29
select the largest level of investment for which incremental economics are satisfactory. This is two inches of insulation as deter-
Alternative
Rate of Return
1',-0"
29"/"
2"-0'
3',-j',
31"/"
2',-1"
3',-2',
23%
37%
-17o
9o, 2" is the largest level of investment satisfying both the individual and incremental economic criteria and is the-ec6nomic choice.
193
Equipment
projected Annual
Savings
.--qg$_
Level 1 $200,000
Level 2 $350,000
$125,000
$18O,0OO
NPVI = 125(P1AZO"/"5)
ZOO
2.1 06
NPV2 = 1 9O(P/ AZA%,3)- 3S0 +$29.08.
=
194
B) 5 Year Life
200 = 1 80(P/A2g7",n)
350
=2.727
Costs
\\''hen income or savings precedes cost, ROR analysis leads to the calculation of "i" values that have rate of reinvestment requirement meaning instead
of rate of return meaning. These results must be used very differently than
ROR results since "rate of reinvestment requirement" results greater than the
minimum ROR are unsatisfactory (instead of satisfactory with regular ROR).
This is illustrated in Examples 4-9 and 4-10.
195
A)
c = $100,000
B)
= $100,000
1............5
I = 941,060
L = $305,200
I = $41.060
--='
L = $0
C=$0
= 941,060
= $41,060
1............5
L = $305,200
I'
196
lf you look at "B-A", you get incremental income followed by incremental cost so the following rationale-applies:,.,. ;i. ;;
B-A)
C=0
l-$41,060 l=$41,060 +
c = 9305,200
1............5
305,200(P/F;,5)
,'B,'
(This B-A "i" value does not have rate or return meaning. lnstead, it
represents the rate at which funds must be reinvested to cover the
year five future cost of 9005,200. See the foltowing discussion)
The incremental numbers and trial and error "i" value obtained,
are the same for "A-B". However, note that on the "B-A" time diagram incremental income is followed by cost. tt is physicaily impossible to calculate rate of return when income is fottowed by cost.
You must have money invested (cost) foilowed by revenue or savings to calculate rate of return. when income is foilowed by cost you
calculate an "i" value that has "rate of reinvestment requiretnent,'
meaning. The "B-A" incremental "i" value of 20"/" means the investor
would be required to reinvest the year one through five incremental
incomes al20"h to accrue enough money to cover the year five cost
of $305,200. lf the minimum ROR of 1Oo/o @presents investment
and reinvestment opportunities thought to exist over the project life,
as it should, then a reinvestment requirement of 2a% is unsatisfactory compared to reinvestment opportunities of 107", so reject ,,8,,
and select "A". This is the same conclusion that the "A-8,, ROR
analysis gave.
Summarizing several important considerations about the RoR analysis for this problem, for the incremental RoR analysis of alternatives
"A" and "8" we discussed the need to subtract alternative ,,B,,from
alternative "A" so that we had incremental costs followed by incremental revenues. Then we discussed what happens if you incorrectly subtract alternative "A" from "B" as follows:
B_A)
C=$0
| = 941,060
1=941 060
= g3o5,2oo
1S7
sbo,ooo
"B-A"
264,492
CUMULATIVE
CASH
200,000
POSITION
tor i = 20"k
100,000
345
Figure 4-4 cumurative cash position for rncome preceding
cost
Given that
198
where at a 10% ROR. However, if "B-A, incremental income precedes cost, we would be rejecting projec! ,,B',, becausE the "B-A"
rate of reinvestment required al2o"/" exceeds the other opportunities we have to invest capital.which is assumed to be @o/o. ,
Future Worth Protit Anatysis from 9100,000 tnitial lnvestment
A) FW Profit = $305,200
6.1 05
3.791
NPVg = 41,060(P/A16./.,5)
00,000 = +$SS,70O
'199
PVR4-3 = (89,500
When each of these evaluation methods is properly applied you consistently come to the same economic conclusion. you only need to utilize one method to make a proper evaluation. Here, as in other examples
throughout this text, multiple criteria solutions are presented to illustrate
the consistent results obtained with any of the evaluation methods.
Proper incremental analysis is the key to the evaluation of mutuaily
exclusive alternatives where only one alternative may be selected.
12.0 25.0
Costs: -5.0 -4.O -4.A.
Year 0
Net CF: 7.0
21.0
lncome:
...-4.O
NPV @ 15.0o/o: 7 o
- 4.0(P/A15,9)(P/F15,.1)
! ?](PiFrs,r)
>
0,
acbeptable
$8.66
=
200
#?;?y:i ili?'l*f
q,
=
810
oq
o
1o
zo
'llk 15k
2Ao/o
(s)
(10)
Discount Rate
202
A) C = 182
l=
B)
C=250
100
l=
184
l=
100
l=
100
l=
184
203
C=68
l=84
l=84
C = 100
6g = 0
i = 0"/" : 84(2.000)
i = 10"/": 84(1.736)
- 100(1.0000) -68 = 0
- 100(0.7513) - 08 = +2.69
i = 15"/": 84(1 .626) - 100(0.6575) 08 i.2.89
- =
i = 20"/": 84(1.528) - 100(0.5787) OS +2.48
- =
i = 307" : 84(1 .361) - 100(0.4552) 68 = +0.80
i = 40"/": 84(1 .224) - 100(0.3044) 6S
- = -1 .62
i=0% and i=33"3% are duar rates of return by triar and error.
--t--F+-_]%
50%
100%
rL
++
--f-
-r
rt
+
-T
Figure 4-6 NPV vs Discount Rate For Cost, lncome, Cost
204
100
Cumulative
Cash
50
Position in
Thousands for
i=0%
i=
33.3%
0.0
-50
-68
-1 00
i;;." ilffi;;
.*n
182= +$28.6
1.528
NPVB = 184(?lAZA"k,Z) -.ZSO +$31..1 +_ Select ,,8,,,
=
Largest NpV
01
l=$84
l=$84
C = $1oo
23
C=$84
C=$84
F = +$221.8
2.200
1.200
where F = 84(F / A2g"/",2)ff /p
2O%,1) = +$221
.B
206
F
l-== +$121.8
3 +,:
l=$84
01
Modified PW Eq: 0 = -125.87 + 84(PlA1,2)
i = 21.6/o > 2Oo/o, Select "B"
NPV
Figure 4-8 NPV vs. Discount Rate For Modified PW Cost Analysis
C=$68
B-A)
l=$84
l=$84
6 = 9100
3
An Outside
lnvestment C = $57.g7
at i = 29"1o
= Total
| = 9100
23
0.5787
where "C" at time 0 = 57.87= 100(P/F;.=
20"/o3)
l=$84
l=$84
= $125.87
0=-125.BZ +84(p/Ai,2)
to bring costs following revenue back one year at a time until they are
offset by income, as the following illustrates.
B_A)
C=$68
l=$84
An Outside
lnvestment
at i* = 20"/o
C=$68
0
Modified PW Eq.: 0 =
= 9100
C = $83.3
I = 9100
23
whereCatyear2=
= Total
l=$84
0.8333
1 OO(P lF
2g"/", t ) = $83.3e
l=$84
I = $0.7
208
All of the analysis methods utilized for this example, other than
regular ROR, have selected alternative "B" consistenfly. Any of these
techniques can and should be used in place of regular rate or return
analysis when the investment, income, investment type of analysis is
encountered. The combination rate of return, rate of reinvestment
meaning associated with cost, income, cost dual rates of return is
what makes the dual RoR results useless for valid economic decisir:ns. The existence of dual rates is algebraically caused by the sign
changes in cost, income, cost equations. This can be illustrated for
incremental "B-A" analysis in this example.
B-n; c
:igq
l=$84
l=$84
C = $100
Bailt(+i)) + 8a(1/(1+i))2
100(1/(1+i))3
Substirute X = (1/(1+i)):
0 = -68 + 84X +84X2
100X3
l=40
l=40
l=40
l=40
l=40
C=140
210
70 = 0
40(5.000) - 140(1 .0000) 40(4.329) -140Q.7462) 40(3.993) - 140(0.6302) i = 15/" 40(3.352) -140(0.4323) i = 20o/" 40(2.991) -140(0.3349)i = 25"/" 40(2.689) -140(0.2621) i=30% 40(2.436) - 140(0.2072) -
+.
70 = -10.0
70
-1 .3
70
+1.5
70
+3.0
70= +2.7
70
+0.9
70
-1 .6
=
=
=
=
=
Note that due to the "parabolic variation" of the NpV type equation results versus "i", by interpolation, Npv = 0 fgr the dual rates of
return of 6.40oh and 26.780/, Each of these rates makes the cumulative cash position zero at the end of project-life. Both rates involve
a combination meaning of rate of return on investment in early project life and rate of reinvestment rate in the later project years.
These dual rates cannot be used direcily for decision making pur
poses as ROR results. However, the dual rates do provide some
useful information because they bracket the range of minimum rate
of return values for.which project net present value is positive. This
tells the range of 'ri " for which the project is satisfactory. whenever
dual rates exist, it is easiest to rely on NpV analysis for decision
purposes. However, going to Growth RoR analysis or present worth
cost modified RoR analy.sis is equally valid, but generally more
work. NPV calculated at "i^" always leads to correct economic decision in this situation, whereas the dual rates problem makes RoR
analysis more confusing.
2.991
N
PV @ i* =2O/" =
qA(P I AZOo/o,S)
0.3349
ltr;O(P lF 2g/",d
70 = +$2.754 > 0
The NPV analysis is quick and simple to make and the positive
NPV result tells us the project investment is satisfactory, although the
NPV of +2.754 is only slightly greater than zero compared to the
magnitude of costs that generated it, so project economics effectively
are a break-even with investing elsewhere al2O"/o.
211
-t
-60
Figure 4-g NpV vs Discount Rate for Cost, lncome,
Cost
|
--r&..
212
0.3349
6 = $70 * $1a0(P/FZO*,O)
1............5
Growth ROR
lnitial Project
C=$70
0
l=940
l=940
1..........5
C=9140
6
_
0
c=940 c=940
1..........5
7.442 1.200
F=$357.20
C=$70
o
C=9140"-
F=$357'2
213
income.
C=19.90
I=40.00
Net l=20.1 0
3'
Dttr
C=63.88\
C-110.66\
\
l= 4o.oo t"ro,\"=ro9
20,1.
- \Net +4!!A e)rro..,
\Net c=
C=23 88
76.66
56
= 20.1
= 22.75% > i* =
ZO"k so satisfactory
This modified RoR result is several percent bigger than the initial
present worth cost modified result. This is oecause the
two modified
RoR results relate to very different initial year 0 investments. The
results are really equivalent and give the same economic
conclusion
when compared to the 20% minimum RoR. Remember that you
cannot and should not look at the magnitude of RoR results and
think
214
income.
EXAMPLE
i
t, biffiffi;Ji;"r",;;
"
Present C
0129456
Accelerate C=
0129456
Solution:
The-"present" producing project is crearry satisfactory
since
costs for deveropment.have arready been incurred (so
they are
sunk). For no additionar costs to be lncurred, the ,,present,,
project
revenues are projected to be generated. This relates
to
an
infinite
percent return on zero dollars invested in
the present project, an
economically satisfactory project. The accererated plolect
total
investment RoR is 2oo%. However, this RoR does
not need to be
calculated because knowing the present project is
satisfactory, we
can go to incremental analysis to determine if incremental
invest_
ment dollars spent on the accererated production infiil
driiling pro_
gram are justified economically by incremental
revenues. The
incremental diagram involves cost, income, cost as follows
because the negative incrementar incomes in years
4, 5 and 6 are
Anarysis
215
,4
310(P/F1 2/o,4)
,1
11"/o
216
Note that any investor who treats either of the positive dual rates of
ond 257" as rate of rturn comes to,the wrong economic conclusion in this analysis. when cost follows revenue, you must modify
the analysis to eliminate cost foilowing revenue oefoi5you can make
ROR analysis.
17o/o
producing Analysis
1234
L=4
C=25
Replace
Later (B)
C=0
L=9
Solution:
Analyze "A-B" to get incremental cost followed by incremental savings. However, it is impossible to avoid having incremental costs and
negative incremental salvage (effectively cost) in years 3 through 6,
giving the dual ROR problem.
R = incremental savings which are equivalent to revenue.
A_B)
L=-5
A modified RoR analysis is needed to eliminate cost following revenue or savings. There is litfle value obtained from calculating the
dual rates of return except to satisfy curiosity, but the dual rates for
this analysis are +22.32/" and -13.03%.
0.8696
0.7561
2.855
0.7561
0.4323
5(P/F15%,6) -20 = +1.31 >
0,
so accept,,A,,,
reject "B"
C=50
l=30
C=100
l=30
l=60
l=60
l=60
Project years
219
{.9
Analysis
220
01
5.0
Year:
Net CF:
.-12.O
23.0
-4.O
-4.0
8.0
CF:
5.0
8.0
-4.O.
-4.0
Year:
19.0
10
-4 ofiill#x8;Piil
) = -15.61
8(3l3ll,nn,
. , e = 62.32
cost-income-cost.
2.0c
1.50
E
c
1.00
o
o
E 0.50
o-
zo
0.0c
(0.50)
'47o -27o
Figure
Oo/o
+I1
16%
Discount Rate
222
1
2
3
4
lnvestment, $
Operating Cost
Savings Per Year, $
10,000
6,000
25,000
10,000
35,000
15,000
50,000
17,000
".onon.,i.
0".t.
cumulative NpV.
224
2)
C=$30,000
ROR = 40%
I = 920,000
I = $20,000
ROR = 337.
l=$10,000
.l=$10,000
3)
L = $so,ooo
C = $20,000
L=$30,000
=$5,000. : .. .. . . . . I =$S,OOO
L=$20,000
Solution:
Maximize Gumulative NpV
1.736
.8264
S0,OO0 = +$26,033
3.791
.6209
NPV2 = 10,000(PlAlO.t",S) + 30,000(p lFfin,S)- OO,O0O
= +$26,535
4.868
.5132
NPV3 = 5,000(P/A
10"/",i + 20,000(plFlyo/o,7) _ 20,000 = +$14,605
1)
.t C=$50,000 I=$20,000 l=$20,000
225
L=9S0,000
C = $50,000
Rein-
-01
VESt
C=$20,000 C=$20,000
2. .. .. .7
F = +$148,210
1.772
1.611
where, F = 20,000(FlP13"7",6) + 70,000(Flp19"7",5 ) = +$148,210
t+
Rein- v^$50,000
VESt
F = +$148,210
1 ....
.......7
Gi'owthHCR=t=17"t'o
1...........s
L=$30,000
c=930,000
Rein-
-0
VESt
C=$10,000 C=$1C,000
.....5
6.1 05
where, F =
[1
P=+$110,170
1.21
2+
ReinVESt
v-
$30,000
.... .......7
F=+$1 1 0,1 70
GrowthROR-i=20.4/"
J)
^\ C=$20,000 l=$5,000 l=$5,000.L=920,000
^
ReinVest
C=$20,000
C=$5,000 C=$5,000
1...........7
9.487
where, F = 5,000(F/A 1O%,) + 20,000 = $67,430
F=$67,430
226
3+
ReinVest
F=$67,430
...........7
Both PVR and B/c Flatio results indicate projects z and 3 are the
economic choices consistent with Growth RoR and cumulative Npv
results. Properly calculated ratios and Growth RoR results will
always rank non-mutually exclusive alternatives in exacily the same
correct order.
It is instructive to note that a higher minimum RoR such as i* = 257o
causes the choice to switch to alternative 1. when you have good reinvestment opportunities, the short life high RoR project 1 is economically more desirable than when reinvestment opportunities are poor.
NPV for i* =
25o1o
1.440
N PV 1
= 20,000(
P I AZS"k,Z) + 50,000(
= +$10,800
.6400
P lF
ZS"1",Z)
2.689
.3277
PV2 = 1 0,000(P / A25"y.,5) + 30,000( P /F
25"/",5)
= +$6,700
3.1 61
S0,
gO,0O0
000
.2097
20,000 = +$0
PVFI
for i* =
25o1o
0120,000 = 0.00
since the Growth RoR results for pro.iects 1 and 2 were equal, we
expect the ratios to be equal. once again, as rvith groivth RCil, h,ro
mutually exclusive choices exist for spending $sc,obo on ncn-mutually exclusive projects 1, 2 and 3. we can either invest in project 1, or
in the combination of projects 2 and 3.
PVRl
0.22
PVR2a3
(6,700 +
O)
Since the same $50,000 would be invested either way, select the
maximum PVR which is project 1. This is consistent with Growth
RoR results and conclusions. with both pvR and Growth RoR
results, the projects were put in the desired selection order but the
budget constraint caused us to analyze several mutually exclusive
choices before making the final investment decision.
The next example has a primary objective of emphasizing the necessiry
of netting togerher all inflows and outflows of money ana wJrking with thl
resultant net cash flow each compounding period in either Growth RoR
or
Ratio calculations.
228
, ,
ROR
"
l=$110 l=$110 l=$110
C=$100
C=$2OO OC=$0 OC=$0
A)
0
1
2 ....... . . .8
l=$150 l=$150
6=$90 OC=$40 OC=940
B) c = 9100
01
2 ..........I
157o.
4.160
NPVg = [110(P/A15./",2)
.8696
200(P/F1 s"/",i- 100 = +$219.60
.8696
90](P/F1
S"/",i
100 = +$219.60
.8696
10)(PiF 15"/o,1)] = +1 .23
.8696
PVR3 = 219.6 / [100 + 90(P/F15%,1)] = +1 .23
lf you incorrectly do not net the project "A" year 1 cost of $200
against the revenue of $1 10 before calculating the ratio denominator,
you calculate
.8696
PVR4 = 219.6 / [100 + 200(P/F1 S%,i] = 0.80 = incorrect PVR4
This ranks project "A" as economically inferior to project "8" which
is not the case.
C=$100 NetC=$90
0
Reinvest
lncome
@ i" =15"/o
l=$110
l=9110
2..........8
C=$110 C=$110
2........8
F=$1,217.40
1"i.067
c=$100
C=$90
.......8
F=$1,217.40
Tb properly rank projects using Growth RoR, bring the net costs
beyond time zero back to time zero by discounting at the minimum RoR,
which is 1So,a for this anarysis. This enables us io calculaie rate of growth
of a single year 0 sum of money which wilt always be identical to the
denominator of a properly calculated pvfr or B/c Ratio. By caiculating
Growth RoR on year 0 single sums of money, it is clear that projects with
the largest Growth RoR are our choices. Those projects must generate
the greatest future value possible from available investment dollars.
Growth RoR
pw Eq: 100 .
e0(p/P1T"7.: 1) = 1,212.4(p/Fi,s)
GrowthROR=i=27.14"h
since the net costs and incomes on the "8" diagram are identical
to the "A" diagram, Growth RORB = Growth ROR4 =27.14/o
As with PVR analysis, it should be evident that if the year 1 costs
and revenues for project "A" are not netted together, a Growth ROR
is calculated based on year 0 cost of $100 and year 1 cost of $200
and the 23.79% Growth RoR4 result would rank "A" inferior to "8".
This is not a valid result.
230
when investments have different starting dates, whether they are mutually exclusive or non-mutually exclusive, it is necessary to use a common
evaluation time for NPV or PVR results that lead to valid economic decisions as the following variation of Example 4-18 illustrates.
EXAMPLE 4-19a Analysis of Mutually Exctusive or
Non-M.utually Exclusive Alternatives
With Different Starting Dates
Re-evaluate alternatives A and B in Example 4-19, first as mutually
exclusive alternatives and second as non-mutually exclusive alternatives, considering that investment alternative B starts closer to year 1
than year 0 for i. equal to 't5%.
B)
C = $100
$150
I
|
9150
=
=
6=$90 gg=940 66 = 940
3........9
Solution:
each project, you get the results shown in Example 4-19 which lead
231
0.8696
200(PlF tS%,1)
- 100 = +$219.60
4.160 0 7561
0.7561
NPV6 = i 10(PiAt 5"r
,)(PlF11orc,Z) - 9O(P/F1 S"/",2)
0.8696
gC.gB
1
C0(P/F1
Sozt,,1 ) = +91
lf A and B are mutually exclusive, the maximum Npv (alternative
A) is the economic choice. This is a different economic result than
the break-even economic conclusion reached in Example 4-ig
where the same projects were assumed to have the same starting
dates. Therefore, project start date affects mutually exclusive alternative analysis conclusions. lf the alternatives are non-mutually exclusiie, rank them with PVR as follows.
Present Value Flatio (pVR)
0.8696
Year 0 PVR4 = +219.6/[100+(200- 110)(p/F15,1)] +1.23
=
0.8696
0.756'1
232
and often incorrect economic decision-making. Similarly, with ratio analysis it is necessary to use break-even cutoff rates of zero for PVR and one for
B/C Ratio. You will not get economic decisions that are consistent with
results from other valid techniques if you raise the ratio cutqff rate to say,
0.25 for PVR or 1.25 for B/C Ratio as an alternative to raising the minimum
ROR and leaving the cutoff at zero for PVR and one for B/C Ratio. The following example illustrates considerations related to these points.
I = $34.67
I = $34.67
B) C = $100
I = $16.67
t= $16.67
Solution:
By Trial and Error, ROR4 = 21.7"/", RORB = 16.0%
Decision
Criteria
i* =
12o/o
i* =
15o/o
i* =
20"/o
3.70
NPVA
NPVg
.*+25.00
+16.20
+ 4.80
PVR4
PVRg
+
+
.25
.25
+
+
B/C Ratio4
B/C Ratiog
+
+
1.25
1.25
+ 1.16
+ 1.05
+ 1.04
13.1%
13.1%
15.6%
20.1%
18.4"/"
Growth ROR4
Growth RORg
.16
.05
15.2P/"
-18.50
.04
.18
.82
23t
lf "A" and "8" are considered to be non-mutually exclusive alternatives, PVR, B/c Ratio, anci Growth RoR, are the valid ranking techniques and all indicate "A" is better than ,,8,, for i* 157o and 2O%.
=
Now iet's analyze the effect of using i* = 1}o:o tc handte tirne value
of money in ratio calcurations, but effictivery in.r"rul ii;,, by raising
the cutoff for acceplable projects from zero to 0.25 with pvR and
from 1.0 to 1.25 with B/c Ratio. This is an evaluation aporoach
sonretimes used in industry practice. Notice ii leads to the conclusion
in this case that "A" and "B" are equivalent,',r,hti,lr the-,.are r:-ir_i._;aliy exclusive or non-mutually exclusive. Actually raising ,,i*', to 15%
or 20"/" shows clear economic advantage to "A" for the higher ,,i*,' values with all standard techniques of analysis. Aiso notice that for i*
i2'lo. all merl-rods show the aliernatives are equivalent. This means=
incr"emental RoR analysis ("8-A" to get incremental costs followed by
incremental revenues) will give the incremental ,,B-A" RoR to be
12'/". Treating alternatives "A" and "B" as eco*nomically equivalent is
the conclusion given by ratio calculations at i* = 12/o with increased
cutoff values of 0.25 for pVR or 1.2s for B/c Ratio. This expliciily
means that a 12/" incremental RoR on "B-A" is satisfactorv. This is a
misleading conclusion if other opportunities really, exist to invest dclkrs-at an RoR greater than 12%, which raising the cutoff rates on
PVR to 0.25 and B/c Ratio to 1.25 implies. Since this approach
involves inconsistencies in economic conclusions, it seems undesirable to use it. However, it can be argued that the differences in
results from increasing the ratio cutoff instead of increasing ,,i*,, are
small and not significant. Regardless, it is important to be aware that
this approach may give economic results and conclusions that are
234
4.ll
MutuallyExcIusiveAlternativeA:ralysis...:.:.b.
Rate of Return or Growth Rate of Return. With either regular ROR or
Growth ROR analysis of mutually exclusive alternatives you must evaluate
both total investment ROR and incremental investment ROR, selecting the
largest investment for which both are satisfactory. Use a common evaluation life for Growth ROR analysis of unequal life alternatives, normally the
life of the longest life alternative, assuming net revenues and costs are zero
in the later years of shorter life alternatives.
Net Value Analysis. With NPY NAV or NFV analysis you want the
mutually exclusive alternative with the largest net value because this is the
alternative with the largest investment that has both a positive total investment net value and a positive incremental net value compared to the last
satisfactory smaller investment. When using NAV or NFV to evaluate
uncqual lit-e altematives vou must Llse a common evaluation life, normally
tht life of the longest lit'e alternative, assuming nel revenues and costs are
zero in the later years of shofier lit-e alternatives as with ROR analysis.
Ratio Analysis. With ratio analysis of mutually exclusive alternatives
using either PVR or BiC Ratio, it is necessary to evaluate both total investment ratios and incremental investment ratios. Analogous to ROR analysis,
the mutually exclusive alternative with the biggest total investment i'atio
often is not the best economic choice. A bigger investment with a somewhat
smaller ratio often is a better mutually exclusive alternative choice.
Future Worth Profit Analysis. Calculate the FW Profit that can be generated by each alternative*project if profits and salvage are reinvested at the minimum rate of return, "i'''". Select the project that maximizes FW profit for the
investment money available to invest, With this method ),ou must compare the
FW profit for the same investment dollars in all cases. by assuming the budget
money not required in one project will be invested elsewhere at "i*".
Dual-i-Values
Dual-i-values relate to the multiple solutions that occur when cash flows
result in investments generating revenue that are followed by more investments. All dual-i-values contain a combination of rate of reinvestment and
235
rate of rerurn meaning. rvhich makes them useless for RoR analysis in
the cash flows were described incruding Grc,urth RoR. the Escrow
Approach anij thc Ytar-by'-!'ear Approach. In euc:h present north m,;dificrti0n. cash flou's are adjusted at the minirnum rare of return tit eliminate r\e
exisience of cost-income-cost. Each of the present u'cri'th rnodificatiops
resulis in the same NPV. This n'reans that cven rhough the i:pproaches genrrate nrodifii-:d ROR results of varying rna-tnitudes, the eccr.riirnic conclusions
r.vill always be consistent with NpV.
Rate of I{eturn or Growth Rate of Return. Regular RCR analysis cannot be used to consistently rank nou-mutuallv exclusive alternatiyes. Use
cror,',rh RoR and rank the alternatives in ti-re order of decreasing Growth
RoR. This will maximize protrt from avaiiable investmr:nt cirpital. use a
common evaination lif'e r'or Growth ROR anall,sis of unequal life alternir_
iives. normally the life of the longest alternative.
Net value Analysis. with NPV NAV or NFV analvsis of non-murua:11,
exciusire pi'ojects, seiect rhe gloup of projects that will maxirnize cumulative net r-aluc for tlie dollars available to invest. This does not necessarily
involve seiecting rhe project with lar-sest net valnc on inclividual project
investrnent. when using NAV or NFV to evaluate unequal life alternatives
you must use a common evaluation life, normally the life of the longest
life alternative.
Ratio Analysis. Ranking projects in the order of decreasing present value
ratio (PVR) or B/C Ratio is the easiest u,ay of selecting non-mutually exclusive projects to maximize cumulative NpV for available investment dollars.
l'uture.lYorth Profit Anall,sis. carcurate the FW profit that can be genif profits and sall,age are reinvested at the
minirnum rate of return, "i'". use a comnon evaluation life equal to the
longest life alternative if unequal life projects are involved. Select the group
of investment projects that will maximize the cumulative FW profit for the
money available to invest, analogous to the way Npv and NFV are applied.
Assume that any odd dollar amounts can be invested elsewhere at '.i*;', the
erated by each alternative project
236
If you use a valid minimum ROR and apply the discounted cash flow
analysis techniques as described in this chapter and summary, you will
reach correct economic decisions for your cost, revenue, and timing of cost
and revenue project data and assumptions. It is always important to recognize that economic analysis calculation results are just a direct reflection of
the input data and analysis assumptions. With any techniques of analysis,
economic evaluation conclusions are only as good and valid as the data and
assumptions on which they are based.
237
PROBLEMS
A) C=300
0
B) C=900
J=450
I=450
I=450
I=550
I=550
I=850
I=850
I=550
I=750
c) C=1,200 C=800
2.........10
4-3 A double
insulation
Initial
(Inches) Cost, g
Annual Heat
Loss Cost, g
Thickness
00
1
2
3
4
r400
1200
1800
800
600
500
400
2500
3500
Base your results on Net Present value Analysis, then verify them
using Present Worth Cost Analysis.
4-4
4-5
Projected Annual
Savings
Change I
$150,000
$ 80,000
Change 2
$230,000
$115,000'
231
4-6
A)
$200
=
g=U00 I=$110
I=$110
2
C = $200
'A"
C = $230
I = $110 I = $110
i = $110
4... . ..8
C = S180
4-7
A) C=100
0
B) C=150
J=40
I=40
I=40
I=40
I=60
I=60
I=60
I=40
L=100
L=150
240
A friend offers to give you 10 payments of $1000 ar annuar time periods zero through lo.:excepr year three if you give,him $9000 at year
4-8
All
I
I=1000
4..
I = i000
10
RoR.
,d,, 6. ,,g,,
with capital costs, sales and operating costs as shown. All values are in
thousands of dollars.
Sales = 75
100
Op. Costs = 45
Sales
B)
C=150
0.
1....
Sales = 75
Sales
100
Op. Costs = 45
.....5
escalation of operating costs each year is expected to exactly offset escalation of revenue, so profit margins .re projected to remain constant at
$450,000 per year for each of the next years one through 10. Two alternatives for improvement and improvement combined with expansion
are
being considered with projected costs and revenues as shown on the
time diagrams following this problem statement, with all dollar values
expressed in thousands of dollars.
I=450
A)
0
I=450
241
I=450
2.,......10
t
B)
C=
80{-)
I=700
I=7C0
I=700
2........10
I=850
1,050
2........10
best
using RoR. i\iPV and pvR. Then incrcase rhe minimum RoR to 25%
from 15vc over the entire l0 year evaluation lit-e and re-evaluate the
alternatives using both RoR and Npv analysis. Then assume that
the
nrinimurn I?"oR is increased from 15% to 25vo tbr evaluation vears
orie
and two ancl then. stz*ting in year three, the minimum RoR reverrs to
157c again through vear 10.
4-1
242
'A"
4-13 Dctermine the best economic way for a research manager to allocate
$500,000 in the following non- mutually exclusive projects if 1* = 207o'
A)
B)
C =-$1Q0,999
,Offi
L=0
C = $300,000
Ll
L=0
,000
L = $100,000
Use NPV Analysis and verify the results with Growth ROR Analysis
and PVR Analysis
A)
B)
0
0
l
I
.......r2
.... .i
L=$20'000
L=$28'000
Verify the ROR Analysis results with NPV and PVR Analysis.
?43
Al
C = Sl60.0o(i
tr
I=Sl-50,000
C = $,120,0(1.1
ts)
I = $27.':.i;00.
C = 5436,000
I = $500,000
"$
I50,000
L = $50.000
I = $275,000
L = $70.000
.4
c)
sar_
I = $500,000
L = $100,000
use Nl-v'anary.si.
,o a"r"._
n'rine how the 9490,000 shourcr
be spent from an economic viewpoint
if the altematii'es are non-rnutuairy exclusive. Then
use Npv Analysis
Analysis.
Yr
A)
B)
c)
D)
-200
-300
-300
-300
60
-90
2s0
100
100
100
250
r50
-200
200
250
-350
300
300
400
250
-600
400
300
400
244
4-17 lmprovement to a coal mine haul road is being considered to shorten the
overall.haul distance and reduce ffuck cycle times thereby increasing the total
number of cycles per day. The cost of the improvements is estimated to be
$6,0U),000 at time zero. Currently, the trucks make 16 cyclgs per day from
the mine pit to a port load out facility which translates into 2,000,000 tons of
coal being hauled each year. If the road improvement is made, the number of
cycles is anticipated to increase by 257o to 20 cycles per day which translates
into an additional 500,000 tons of annual production from the mine. Total
mine reserves are estimated to be 14,000,000 tons and the coal is sold at an
average selling price of $32.00 per ton with operating costs of $12.00 per ton.
If the haul road improvement is made, the life of the mine will be shortened
from seven to six years due to the accelerated production schedule. With the
modified haul road, total production in years one through five would be
2,500,000 tons per year with year six production of 1,500,000 tons.
For this acceleration problem, use rate of return analysis to determine
if the investment in the haul road improvement should be made today.
The minimum acceptable rate of retumis l5%o.
4-18 Improvement to a mine haul road is being considered to shorten the overall haul distance and reduce truck cycle times, thereby increasing the total
number of cycles per day. The cost of the improvements is estimated to be
$6,000,000 at time zero. Currently, the trucks make 16 cycles per day
from the mine pit to a crushing facility rvhich, given the truck perfornrance, capacities and haul distance, translates into 2,000,000 tons of ore
- being hauled each year. If the road improvement is made. the number of
cycles is anticipated to increase by 257o to 20 cycles per day which translates into an additional 500,000 tons of annual production tiom the mine.
Total rnine reserves are estimated to be 14,000,000 tons. If the haul road
inrprovement is made, the life of the mine will be shortened from seven to
six yeilrs due to the accelerated production schedule. With the modified
haul road, total production in years one through five would be 2,500,000
tons per year with yezr six production totaling 1,500,000 tons at which
tirre the resenres wor-rld be depleted. For each alternative, the average ore
is 0.09 ounces per ton with a 0.85 recovery rate. The average selling
-erade
price is $350.00 per ounce while the operating costs are S 190.00 per ounce
beginning in year 1. The minimum acceptable rate of return is 15.0Vo.
For this acceleration problem, use rate of retum analysis to determine
if the haul road improvement can be economically justifred. Then verify
your findings with a net present value analysis.
4-19 Two alternatives exist for you to invest $100,000 as shown on the
fol_
lowing time diagrams. consider risk to be identical for each investnrent. Assuming your rninimum discounr rate is L5.\va, determine the
economically better choice using the rate of retu?n, net present value,
present value ratio, grorvth rate of return and future worth profit.
4-20
A)
-250
B)
-250
11532
.....115.32
1,206.7
A proposed investment
stream from development ccst and-product sale profits, ancl abandonment costs. use rate of return analysis to determine if this investment
are in thousands.
BTCF
4-21
_2g4
A natural gas distribution company is evaluating the economic desirability of replacing or repairing existing gas mains in a small town. At
the present time, with the existing gas mains, it is estimated that
100,000 Mcf of gas is being lost per year and that this gas could be
sold to colporate customers at $2.00 per Mcf. The cost of replacing
of the mains ri'ould effectivery eriminate all gas loss for the next 10
vears. The cosr of repairing the gas mains is estimated to be
$400,000
rvhich would reduce annual gas loss to 25,000 Mcf at year one (allocate to the end of the year), with gas loss increasing by a constant gradient of 6,000 Mcf per year in years following year one. Use present
rvorth cost analysis for a l0 year evaluation life and i*
= l5.0vo to
determine from an economic viewpoint if the gas mains should be
replaced, repaired, or left in the present condition. verify your cost
analysis results with incremental NpV.
CHAPTER 5
5.1 Inflation
Many people use ihe terms inflation and escalation interchangeably but
generally, as usec in this textbook they have different meaning. The term
inflation is often associated with increases in prices for goods and services
that is the result of "too many dollars chasing too few goods," and is commonly measured by various indexes, the most common of which is the consumer Price Index or cPI. A more refined definition of inflation might be,
"a persistent rise in the prices associated with a basket of goods and services
that is not offset by increased productivity." Deflation could be defined as
an overall decline in prices for a similar basket of goods and services . Escalation ort the other hand refers to a persistent rise in the price of specific
246
247
lnflation
Supply/Demand
Technological Changed
Market Changes
Environmental Effects
Political Effects
Miscellaneous Effects
r.:
248
other hand people on fixed incomes with little or no debt clearly are hurt by
inflation because the purchasing power of their in9.n$9 gI capital decreases
each year approximately proportional to the annual inflation rate. It is necessary to discuss.how inflation rates are derived to anrplifythe meaning of
the last stiltement.
249
There are two basic evaluation tecrmiqttes that can be used with
equal
ualidity to handle inJlation and escalation properly in economic
analyses.
Tht.t are escalated doLlar analy'sis and cansrant rJollar analysis.
The econornic conclusions that are reached are always identical with either
appi.)ach. Escalateci tiollar values refer to actual tlollars of reventte
or cost
tiicti will be realizetl or incLtrred at specificfuture poittts irt tinte.
Elsewhere
in tita literarure yott find escalated dollars ;"eferred to by the tenns crffrent
aL.,iitit's, ir{lcted dollars, nominar doilars, cmd dollars i7 tlr"
day. corrstant
dollur v-alues refer to hypothetical constant purchaiing power dollars
obtained by discounting escarated doilar values at the inflii)n rate
to some
arbitrary point in time, which often is the time that corresponds to the
beginnilry of a project but may be any poini in time. Constait doilars qre
referred to as real dollars or deflated dollars in many places
in the literature. Figure 5-2 relates the definitions of escalated dollars and
constant dol_
lars to a variation of Figure 5-1 used earlier to illustrate how
inflation and
lnflation
Constant
Dollar
Items
SupplyiDemand
Technological Changes
Market Changes
Environmental Effects
Escalated Dollar
Items
Political Effects
lu4iscellaneous Effects
250
referenced to some earlier date. The key to proper analysis and consistent,
corect economic evaluation eonclusions lies in recognizing,that you cannot
nrix escalated dollar analyses and constant dollar analyses. To do so is analoqous to comparing apples and oranges. You must eithercornpare'all alternatives using escalated dollars or you must compare all altematives using con-
stant dollars; and you must remember that the minimum ROR must be
in relation to other escalated dollar investment opportunities for
escalated dollar analyses while the minimum rate of return must be
expressed in relation to other constant dollar investment opportunities for
constant dollar analysis. A very common constant dollar analysis mistake is
for an evaluator to calculate constant dollar rate of return for a project and
then compare it to other escalated dollar investment opportunities such as a
btrnk interest rate, attainable bond interest rates or another escalated dollar
ROR opportunity.
Consider how escalated and constant dollar estimates for costs and revenues are obtained. The evaluatirrn of projects starts by estimating project
costs and revenues in today's prices or values. This establishes what the
project costs and revenues would be if the project occurred today. Next,
since projects do not occur instantaneously, the today's dollar values are
adjusted to project the actual or escalated values that will be realized. If the
increase can be described on a percentage basis, single payment compound
arllount factors, (F/P1,n) can be used to determine the actual value anticiprted at the future point in time. The escalation rate is used as a substitute
value for i. This approach is utilized in many text examples, but may not be
appropriate in actual evaluations depending on the forecasting techniques
utilized. Also note, if you think values may decline, negative escalation
rates might also be used. The actual values anticipated to be realized over
the prolect life form the basis for the escalated dollar evaluation.
N4any investors choose to utilize the anticipated inflation over future
vears as an approximation for escalation. This is one forecast of the future,
but there is no reason evaluations cannot be based on as many separate escalation or de-escalation rates as there are parameters that make up the model.
Curnmodity prices, the price for construction equipment, steel, concrete,
labor and energy to name a f'ew, may not move in direct correlation with the
rilte of inflation. The use of inflation as a proxy for escalation is addressed
in more detail later in the chapter concerning the use of today's dollar values
in evaluations.
If a constant dollar analysis is desired, the escalated dollar cash flows for a
pro.iect must be adjusted to have the anticipated intlation removed from each
expressed
value
ac1
st.,t
inflation is
3vc, then approximately, there should be a 2o/o real
or constant dollar
increase in the price of the product.
Constant $ = Today,s g x (Escalation _ Inflation)
Constant $ $260 x (1.02) = $265
252
gold was $420 per ounce. In mid 2000 the price had fallen to $275 per
ounce. That translates into an annual price decline of. 4.LVo per year (negative escalation) over 10 years. During that same period, U.S. inflattn
(as measured by the CPI) averaged approximately 3.OVo pelyear. Had gold
increased in value at the rate of inflation, the value in 2000 would have been.
t.3439
$420(FlP3Eo,10) = $564 per ounce
Instead, the actual price dropped to $275 per ounce and the corresponding constant dollar equivalent price of gold (in terms of 1990 base year
dollars) dropped as well to:
0.7441
$275(P83o7o,10) = $205 per ounce
It is worth noting that the term "constant purchasing power" has nothing
to do with the price remaining constant each year. Instead, it has to do with
the relative purchasing power of that money over time, If the price of gold
had actually escalated 3.0Vo per year so it just covered inflation, the real
purchasing power of the ounce of gold would still be $420. Obviously more
than inflation is influencing the price of gold and other parameters that
make up our economic evaluation models.
Finally, it is aiso important to note that inflation can have the same
impact on interest rates as that just described in terms of cash flow or the
price of a product. Further, discount rates are influenced irr the same manner
as is introduced in Example 5-l:
Consider the following investment analysis example to illustrate how
today's dollar values are the starting basis to get both escalated dollar values
and constant dollar values and the corresponding rates of return.
EXAMPLE 5-1 Escalated and Constant Dollar ROR Analysis
Today's Dollar Values, C=Cost, l=lncome
co
0
$aoo
2 years
Solution:
$to0
1.200
C1
t5!q/P20%,1)=$1
1.210
B0
le = $+OO(VP
rco/",2) = $484
$ru
Ct
$1eo(p/Frcx.; = g156
lZ = $4Aq(P lF
I Sk,Z) = $3G6
. The,meaning of the constant doilar costs and revenues is as forlows: $156 at year 0 wourd purchase the goods
and services that
$180 would purchase at year 1, if inflation is tSZ p"ry*,
and g366
at year 0 wourd pulghase the goods and services
tnat $+84 wourd
purchase at year 2, if infration is15% per year.
The meaning of these
constant purchasing power doilars is onry varid
when ,"t"t"o to purchasing the average goods and servicei tnat
make ,p in" infration
index that was used to project 1S% inflation per
year.
254
tS6(P/Fy,1) +
366(piFy,2), :?
This constant dollar RoR is compared to the constant dollar minimum RoR to determine if the project is economically satisfactory.
Either escalated or constant dollar analysis of this project, or any
other, will give the same economic decision. To reach a decision concerning the economic viability of this project using either the escalated or constant dollar analysis results we must know the other
opportunities that exist for the use of our money and whether these
other opportunities are expressed in escalated or constant dollars.
For illustration purposes consider that other opportunities exist to
have our money invested at an escalated dollar RoR of 3s%. comparing the project's escalated dollar RoR of 47.7"/" to the minimum
rate of return of 35% we conclude that the project is economically satisfactory. lf we compared the project's constant dollar RoR of zg.s%
to the other escalated dollar opportunities we would be making an
invalid comparison. we cannot compare constant dollar results with
other escalated dollar project results. All results must be calculated on
the same consistent basis before comparison is made. To make a
constant dollar analysis result comparison, we must convert the escalated dollar minimum RoR of 35% to the corresponding constant dollar minimum rate of return, which we then compare to the project constant dollar RoR of 28.s%. Mathematically, for escalated dollar RoR
analysis, the factor P/Fi.n does the job that the product of factors
P/F1,6 x P/F;,,n does for constant dollar analysis of the same starting
escalated dollar values where "i" equals escalated dollar RoR, "i"'
equals constant dollar ROR and "f" equals the inflation rate.
P/F;,n = P/F1,p xPlFi,,n, gives:
1l{1 + i)n = 1/(1 + f)n x 1/(1 + i',)n, or:
1+i=(1 +f)(1
giving
i'=
+i,)
[(1 + i)/(1 +
5_1
f)]- i
Equation 5-1 and its rearranged form are equally valid for the calculation of project rates of return and minimum rates of return. This
means the value of the escalated dollar project.rate of return, "i," can
'
C0
012
'1.000
1.000
F/POZ,2) = $400
That the F/P factors al o"/o equal 1 .0 is clearly seen in the mathematicalformat, where
256
errort
sz,t) = $tzz's
t = $+oo
(F/P1s%d= $528'8
2
C=$100
C = $172.5(P/FtSZ,t) =
o----.--.------1=-2
g150 t= gSZe.a(p/f.,
5.h,2)= $400
1S0(p/F;,,1 )
4OO(plFy,2)
error.
i'=
[(1
.594)l(1.15)]-
1 = 0.386 or 38.6%
+f + i, +fi,
Neglecting the fi'interaction term and rearranging gives the following approximation:
i-f=i'
5-2
258
Escalate
Using F/P",n
Today's $
Escalated
Dollars
Discount
Using P/F;.,6
Net
Present
Value
t-
I e=escalationrate
I f=inflationrate
I i' = escalated $ discount rate
I i.'= constant $ discount rate
I i = escalated $ rate of return
i i'= constant $ rate of return
Discount
Using P/F1,n
Discount
Using P/F;*,,n
1,,,
I
l'/
'#,ii?i'
Analysis
$20,000 Cr = $40,00Q
01
L=0
A) Assume year l development cost will escalate 7"/" per year. year
2 and 3 revenues wiil escarare gr" per year. operating';;i.
ili
'
escarate go/o per year. Mako escatateo c"rrrr
"nlv.]..
B)
the part (A)_escaration assumptions an*given
escarated dor.For
lar minimum RoR of 1s"h, make constant doilar
anarysis of the
c)
co=20
Cl=40(F/Pl"n
i=42.8
1.295
"/o,2)=EJ9
2O(F/pg"/",3)_el
=62.3
-20 -
4r Bpi:l::/",1)
+ 57.86 pilu,!!r",r1
.657s
+ 62.3(P/F1 s"/"5) = +27.49 > 0, accept the project
260
.9434
.8900
.8396
Ct =42.8(P /F 6y",1) RZ=57.86(P/F
Rg=G2.3(p
IF
6y",2)
A11^.g)
^
CO-20___:j9fB
=51.49 '
=S2.AO"'"'"'
constant dollar values are obtained by discounting escalated dollars at the rate of inflation of 6% per year. For constant dollar NpV
analysis we must convert the 15% escalated dollar minimum RoR to
the equivalent constant dollar minimum RoFl for the assumed 6% per
year inflation rate. use Equation s-1 for this calculation as follows:
1l
= [(1 + i)/(1
+f)]- 1 = (1.1S/1.06)-
=0.C849or8.49yo
.9217
.8496
40.98(P/Fg.4go/o,1) + 51 .4g(plFg.49o/o,Z)
.7831
Note that the constant dollar NpV is identical to the escalated dollar NPV within round-off error calculation accuracy. constant dollar
NPV equations are mathematically equivalent to escalated dollar
NPV equations, so of course give the same results. The mathematical equivalency follows:
Escalated $ Calculatiohs = Constant $ Calculations
(Escalated $ Val ue) ( P/F;*,
6) = ( Escalated $ Value) ( p/F1,
since P/F;.,n = (P/F1,n)(p/F;.,,n)
p)
(p/F;.,, n)
P /F
261
/F
a.qg6,Z)
= (0.8900X0.8496) = 0.7561
= -20
4O(,PlF1S"/",1) +
'
SO(p/FlS,t",2)+ S0(p/F1
S"/"5)
washout
262
NPV = -20
- 40(PlFg.ag"/",1)
= +24.8.> 0, so accept
ROR = g2.2%, i*'= 8.4g"/o,So accept
Note the today's dollars equal escalated dollars NpV result is significantly different from the today's dollars equal constant dollars
NPV result. Although the RoR results are 32.2/o for both cases, different minimum rates of return are used for the economic
decision
with RoR in the two cases. These two today's dollar analysis cases
are very differeht and can lead to different investment decisions.
obviously, understanding the escalated dollar or constant dollar inflation and escalation assumptions being made is very important for
correct economic decision making.
263
(A)c--too
012
CC =
(B)
Soiution:
60
aC =72
Ptll4 =
1gg
PWB = 60(1/1 .2) +72(111.2)2
1OO
3) for i* = 10"h
PW4 = 100, select smaller Present Worth Cost, "A"
PWB = 60(1/1 .1) + 72(111.1)2 = 114
(A) c
2}o/o
=.
012t
OC
(B) -
= AOP|IZOW,|
=50
OC
= Z2(PlFZot
=50
,Z')
3) for i* =
10o/o,
(A-B)
100
012
C=
Savings
60
72
=3}o/o, NPV4-B = 60(1/1 .3) + t2(1 11.g)2 -1.00 = -1'1 .2S < 0,
select "B"
Ji
265
- 100 = 0, break-even
i* =1}o/o, NPV44 = 60(1 /1 .1) + Z2(1 11 .\2
- 00 = +1 4.0 > 0,
1
select "A"
A-B) c =
,00
Savings
50
50
i*'=
8.387o
- 100
Oo/o
100 = 0, break-even
Note the identical incremental Npv results for both escalated and
constant doliar analysis, so of course the same economic decision
resulis either way.
Now that we have established that either escalated or constant dollar
analysis properly handled gives the same economic analysis conclusions,
are there reasons for preferring one method over the other? In general it
takes two present worth calculations in constant dollar analysis to achieve
the same result that can be obtained with one present worth calculation in
escalated dollar analysis. r.;ewer calcrrlations means fewer chances for math
elrors. a point in favor of escalated dollar analysis. To make proper after-tax
anaiysis, tax calcuiations must always be made in escalated dollars as must
borrorved money principal and interest payments. For constant dollar analysis. this requires careful diligence to avoid improper mixing of escalated
and constant dollars. with escalated dollar analysis all values are in escalated dollars so this is not a problem, another point in favor of escalated dollar analysis. From a practical and ease of calcuiation viewpoint, there is little to be said for constant dollar analysis that cannot be said more favorably
266
for escalated dollar analysis. However, for those evaluation people who
.want to make constant dollar analysis rather than escalated dollar analysis,
.i
the following steps should be fbllo*ed:
1) Determine the escalated dollar values for all project costs &rd revenues.
2) Convert all escalated dollar values to the corresponding constant dollar
3)
uct units each year for the next two years when the product is
expected to become obsolete. Year 2 salvage value is expected to be
zero. Today's dollar operating costs for years 1 and 2 are estimated to
be $8,000 per year. lnflation is expected lo be 7.0"/" per year for each
of the next two years. lf product selling price is projected to escalate
8o/" per year and operating costs escalate 10% per year, calculate the
year 1 and 2 escalated dollar seliing price that will give the investor a
desired 157o constant dollar ROR on invested dollars.
257
---
Year 2
oC
EscalatedSFrofit
Constant $
Profit
X(100XF/ps
"/",2) = 116.6X
108.0X-8800
(108.0X
116.6X_g,OS0
- S,800XP/F7%,1) (1i5.6X
-g,6g1)(ptF7%,2)
As shown, today's dollar revenues and operating costs are converted to escalated dollar values using the selling price and operating cost escalation rates of B% and 162 respecti-vely. lf you want to
work in escalated dollars you use the resultant escalated dollar profrts shown, which are a function of the unknown today's dollar selling
price per unit, X. lf you prefer to work in constant dollars you present
rvcrth escalated dollar profit at the 7"k per year rate of inflation to
convert escalated dollars to constant dollars.
Escalated Dollar Present Worth Equation Catculations
To write an escalated dollar present worth equation we mu*qt use
escalated dollar values and handle the time value of mcney at the
escalated dollar minimum RoR that is equivalent to the desired 15%
cor,'stant doliar minimum RoR for assumed 7./" per year inflation.
Usirg Equaticn 5-1:
1 = (1.07X1.1S)
1=.2305 or23.O5"h
.81268
30,000 = (108.0X
- 8,800XP/FZ3.OS,t)
.66045
+ (t 1G.6X
9,68OXp/FZS.AS,Z)
30,000 =
(1
08.0X
(1
6.6X
8,800XP lFT"/o,1)(P lF
6y",1
Bureau of Labor Statistics into the CE Plant Cost Index published on a bimonthly basis as a measure of the cost of typical chemical plants. "Chemical
Engineering" also presents the Marshall and Swift equipment cost index bimonthly. No one has a crystal ball to forecast the future accurately, but the
use of available indices can be helpful in determining cost and price trends
and rates of change of these trends needed to forecast meaningful escalation
rates for costs and revenues needed for investment analyses.
C=100
Netll=gQ
Net
12
$Q
Net
13
= $Q
C=100 Netll=gg
01
Net
12
= 61.6
Net
13
= 70.84
where,
1 .100
Net l1 = 50(F/Pt O"/"J) = 55.0
Net
12
Net
13
.100
= 50(F/Pt
.120
g"/",iF|P12./",i
.100
.120
= 61.60
1
1
1 .150
= 50(F/Pt g"7"1)f /P12.7"1)fflP11"/b,i =70.84
270
.8696
.7561
.6575
NPV = -100 + 55(P/F1 S/o1) + 61 .6(P/F 15"/o,2) + 7A.84(PlFt SZ,g)
= +$41.0 > O, so satisfactory
50
Net
12
= 51
85
Net
13
= 56.25
.9091
.9091
Net
13
.9259 .9434
70.84(PlFlOo/",1)(PlF67",1l!lF6"y",1)
=
= 56.2S
271
+ 56.25
.9566 .9391
4"/", 1) (P 6. a6"7", i (P
(P / F
4.S
/F
.9217
/F
g.qg"t,i
lr'henever project costs and revenues involve more than one currency,
e
\ciran-qe rates must be projected fbr each evaltration period to perrnit analysis
272
$1,000
A)
Country Z currency analysis assuming zero percent escalation of all values per year.
Case C) Change the Case B analysis to reflect projected 50% per
year devaluation of Country Z currency against the U.S.
dollar. Assume all project costs, revenues, and salvage values are incurred or realized in U.S. dollars, but do the analysis in terms of Z units. (This could be a Country Z mining
or petroleum project where product is sold internationally in
U.S. dollars.)
Case D) Re-work Case C assuming sales revenue is realized by
selling product (such as electric power) in country Z at the
uniform selling price of 6.0 Z units {(1002/$1.00) x
($0.00/Unit)) per product unit each year. ln other words,
product is being sold to the country Z general population
and the economy of the country will not permit passing
inflation effects through currency devaluation on to the consumer. For simplicity, also assume salvage value is unaffected by exchange rate changes. However, operating costs
are assumed to be affected by exchahge rate changes.
case
E)
, money leverage
*l
case
F)
Solutions:
Case
$600 revenue/yr
19,990 uniisiyr ($0.06iunit)
-10,000 unitsiyr ($0.0ilunit) = _$.t00 operatlng cosVyr
Before-Tax Cash Flow/yr $500 +
=
$400 Salvage atyear
-$1,000
$500
$500+$400 Satv.
ROR = 23.11"/"
NPV @ 10"/" = $198.05 U.S.
Case
-100,0002
50,0002
ROR = 23.11"/"
NPV@ 10%- lg,Bg5ZUnits
Case
C)
274
012
Year
Revenue
Operating Costs
Capital Costs
Cash Flow
-100,000
-100,000
90,000*
+75,00O
225,0a0
+202,500
The devaluation effects have worked for the investor and given better economic results for the assumption that revenue escalates proportional to devaluation. This would relate to an export project such
as mining or oil and gas production project where product is sold
internationally in U.S. dollar prices. Often it is very difficult or impossible to pass on to dornestic consumers price escalation due to currency devaluation effects. The domestic consumer may not have the
C, No
Revenue Escalation
Year
Revenue
- Operating Costs
- Capital
-100,000
-100,000
Costs
Cash Flow
12
60,000
-ru,ooo
45,000
100,000
-22,500
77,500
ROR = 13.36%
NPV @ look =+4,958 Z Units
These results are economically less desirable than the "no devaluation" Case B results, because devaluation is assumed to negatively
affect operating costs but to have no off-setting positive effect on revenue. When leveraged money is involved, currency devaluation can
have much greater effects as the following two cases show.These
cases relate to borrowed money analysis considerations introduced
E)
Case
012
Y'ear
Revenue
- Operating Costs
- lnterest
- Loan Principal
- Balloon Principal
+ Borrowed Dollars
- Capitai Costs
Le,reraged CF
60,000
-10,000
-9,000
-i33;333
-20,000 +22,000
100,000
_10,000
-6,000
-4oooo
+24,000
This leveraged RoR result is much betier than the 29.11% RoR
tor cash investment case B. However, note the NpV for case B is
ti:re same as for case E because the cost of borrowed money which
is the 10% interest rate is the same as the 10% opportunity cost of
capital minimum discount rate.
Case
F)
'/ear
Revenue
- Operating Costs
- lnterest
- Loan Principal
+ Borrowed Dollars +80,000
- Capital
-100,000
12
60,000
-15,000
-12,000
-u.:..
100,000
-22,500
-13,500
-135,000
Costs
Leveraged CF
-20,000
+3,000
-71,000
276
f = inflation rate
lai
Rearranged'
(l+l)(1+i')
i'=
{(1+i)/(1+0}
7'=i-f
277
PROBLEMS
5-1
C=I00
C=200
For cases A, B,
rate of return is
A)
Rer,-600
OC=100
LS.OVo and:
B) using
analysis.
c)
D)
xpv
aotta,
rev_
reu-
5-2 In I988,
5-3
I=$200,000
Co=$5o,ooo
I=$200,000
2............5
A)
Evaluate the project escalated dollar RoR if both capital cosrs and
operating costs are estimated to escalate at l|vo per year from time
zero with income escalating at l\Vo per year.
B)
Make constant dollar RoR Analysis of case 'A" assuming the rate
of inflation for the next 5 years will be t\Vo per year.
c)
5-4 A product that sells today for $100 per unit is expected to escalate
in
price by 6vo in year one, 8vo in year two and,lovoln y"a. three. calcuiate the escalated dollar year three product selling price. If inflation is
expected to be 5vo in year one, gvo in year two and 12vo in year three,
determine the year three constant dollar product selling price.
5-5
5-6 Determine the break-even escarated dolrar selling price per unit
required in each of years one and two to achieve a 15% constant dollar
project RoR, assumtng a 12vo per year inflation rate. AI clor;"r varues
are today's dollar values.
C=$10081
Sales=$1116661 Sales=$X(1000)
___99=$50,000
OC=$50,000
Selling price escalation is l\va per year from time zero when selling
price is $X per unit. operating cost (oc) escalation is r5vo per
lear
from time 0. 1,000 units are to be produced artd sold each year.
It
279
ro acquire a property that will be developed 2 years from now and which engineeri .rii-ut"
wilr have today,s
dollar costs and revenues shown on th. forlowing time
diagram. All
values are in thousands of today,s dollars.
C
C=$200
0inow)
Rer,=5159
Rev=$ 1 59
Rev=$ I 50
OC=$50
OC=$50
OC=$50
Case
2.
Make the anarysis using the today's dollar costs and revenues
assuming they represent consrant dollar values. (This
assump_
3. use escalared
doilar anarysis assuming capital cost (c) escaration will be rzvo per year, operating cost (oc) escararion
wi, be
10Vo per year and revenue (Rev) escalation
Case
will be lOTcper
year.
case
5.
use the escarated dolrar analysis assuming capital costs escalate at l2%o per year and escalation oioperating costs
is
exactly offset by a like-dollar escalation of reveiues each
year which gives uniform profit margins each year.
This com_
monly is called.,the washout assumption,,.
5-8
5-9
5-10 The following time diagram before-tax cash flows are today's dollar
values. The investor has a constant dollar minimum rate of return of
1.0.0Vo and annual inflation is forecasted to be 3.0Vo over the project
life beginning in year 1. All values are in millions.
-r00
-200
r50
150
150
150
A) Assuming the rate of escalation for all cash flows is equal to the
inflation rate, calculate the escalated dollar project NPV and ROR.
B) Based on your calculations in part A, determine the constant dollar
equivalent cash flows and resulting constant dollar NPV and ROR.
c)
per year.
D) Again
and ROR,
I
I
I
,
constant doilar
Npv
CHAPTER 6
6.1 Introduction
In this age of advancing technology, successful managers must make
informed investment decisions that determine the future success of their
companies by drawing systematically on the specialized knowledge, accumulated information, experience and skills of many people. In evaluating
projects and making choices between investment alternatives, every manager
is painfully aware that he cannot and will not always be right. Management
pressure is increased by the knowledge that a company's future depends on
the ability to choose with a high degree of consistency those investment and
market opportunities that have a high probability of success even though the
characteristics of future events are seldom precisely known.
In the previous chapters in the text investment analyses all were considered to be made under "no-risk" conditions. That is, the probability of success was considered to be 1.0 for each investment evaluated. This means
that by expressing risk and uncertainty quantitatively in terms of numerical
probabilities or likelihood of occurrence, where probabilities are decimal
fractions in the range of zero to 1.0, we implicitly considered that the probability of achieving projected profits or savings was 1.0 for investment situations evaluated. We are all aware that due to risk and uncertainty from innumerable sources, the probability of success for many investments is
significantly different than 1.0. When faced with decision choices under
uncertain conditions, a manager can use informal analysis of the risk and
uncertainty associated with the investment or he can analyze the elements of
risk and uncertainty in a quantitative manner. Informal analysis relies on the
decision makers experience, intuition, judgement, hunches and luck to
determine whether or not a particular investment should be made. The quan282
283
which has a 157o RoR based on the "best guess" RoR calculation
approach. would this decision be justifiable if the probability
of success of
alternative 'A" was 50va (or one chance in two) compared with probabila
ity of success of alternative "B" of 90va? It is evident that the manager
needs some measure of the "risk" involved in each alternative
in addition to
Tlrcre ore seve ral different approaches that can be used to quantitatively
ittcorporate risk and uncertainty into analyses. These inctuie sensitivity
analysis or probabilis_tic sensitivity analysis to account
for uncertainty
associated with possible variation in project paramercr;, and expected
284
value or expected net present value or rate of return analysis to account for
risk associated with finite prubabiility of failure., The,use of, sensitivity anatysis is advocated for most economic analyses and the use of expected value
analysis is advisable if finite probability of projectfailure exists. Sensitivity
analysis is described in the first half of this chapter and expected value
analysis is described in the second half.
Sensitivity analysis is a means of evaluating the fficts of uncertairul,^ on
investment by determining how investment profitability varies as the parameters are varied that affect economic evaluation results. Sensitivity analysis
is a means of identifying those critical variables that, if changed, could considerably affect the profrtability measure. In carrying out a sensitivity analysis, individual variables are changed and the effect of such a change on the
expected rate of return (or some other decision method) is computed. Once
all of the strategic variables have been identified, they can be given special
attention by the decision maker. Some of the typical investment parameters
that often are allowed to vary for sensitivity analysis include initial investment, selling price, operating cost, project life, and salvage value. If probabilities of occurrence are associated with the various levels of each investment parameter, sensitivity analysis becomes probabilistic sensitivity
analysis.
It may now be evident to the reader that the term "uncertainty" as used in
2As
change in the total outcome relative to the rate of change in the variahle
being considered u'ill indicate the significance of this variable in the overall
evaluation.
Profits
$O7,OOO
L=$70,000
Solution:
Using the most expected cost and revenue parameters gives:
286
-40
-20
0
+20
+40
42.0
27.5
18.0
11.2
5.8
133.3
52.9
0
-37.9
-67.7
Change in
Prediction
-40
-20
ROR
5.6
13.4
18.0
+20
+40
20.9
22.9
-68.8
-25.5
0
16.3
27.1
Change in
Prediction
40,200
53,600
67,000
80,400
93,900
-40
-20
0
+20
+40
ROR
3.6
11.0
18.0
24.8
31.5
-80.2
-39.0
0
37.9
74.8
287
42,004
56,000
70,000
84,000
98,000
Change in
Prediction
-40
-20
0
+20
+40
ROR
15.9
16.9
18.0
19.0
20.0
-11.9
6.0
0
5.4
10.8
288
Solution:
Best Case
Expected Case
Worst Case
240,000
67,000
70,000
288,000
53,600
56,000
5
3.7
lnvestment 192,000
Annual Profit
80,400
Salvage
84,000
Project Life in yrs.
5
ROR, %
36.4
18.0
The results indicate that the project is satisfactory for the best and
most expected conditions but unsatisfactory for the worst conditions.
More information is needed on the expected probability of occurrence of the worst case conditions to reach a valid and meaningful
decision.
The best, worst and most expe-cted sensitivity analysis results give very
useful information that bracket the range of project ROR results that can
reasonably be expected. This is the type of information that managers need
to reach investment decisions. It is very important to recognize that
although a project ROR greater than the minimum rate of return is predicted
for the most expected parameters, the result is based on parameters which
are subject to variation. This variation should be analyzed over the full
range of possible results utilizing the best engineering and management
judgments of people involved with a project.
289
The drstributions in Figure 6-1 all have their values symmetrically distributed around the most likely value (the familiar bell-shaped curve is an
example of this distribution). A distribution of this type is called the normal
distribuiion. If the most likely value is shifted to either side of the center of
the distribution, then it is refered to as a skewed distribution. The nonnal
distributiotr and the skewed distribution are botlt special types of a general
cLass of cttrves known as densitl, functions. In rhe remainder of this discr,tssion normal distributions will be referred to as such and the terru density
function will be used to describe probability distributions that are not normal. The shape of the distributions will be determined by the nature of the
variables they describe.
290
trl
uJ
o
zu
zul
(f
cE
f
- MEAN
,r'
tr
(r
:)
o
o
o
IL
o
()
u-
tJ
co
co
)d]
o
E
o
cc
(L
INTERMEDIATE RANGE
EXAMPLE 1
tl
UL
o-
LL
SMALL RANGE
EXAMPLE 2
uJ
zul
0c
c(
o
o
IL
o
F
-)
c0
o
(r
(L
PARAMETER VALUES,
LARGE RANGE
EXAMPLE 3
1.0
no
i
,!
0.9
,_a
0.8
0.7
0.7
0.6
0.6
0.5
0.5
,:1
:C
o-!
oi
>x
=*
E
f
O
Pa:a;'le'er Values
lntrinei;ate fiange
Example
o.4
0.4
0.3
0.3
4.2
0.2
0.
0.1
0.0
i-:
0.0
'1.0
0.9
io'
4.7
.c.6
oI
.>;
0.5
6LJ
E=
tr
0.4
=
O
0.3
0.2
0.
LL
Values
parameter
Large Range
Example 3
0.0
UL
parameters such as initial investment, product selling price per unit, priaucdon
rate or
292
sales projections, operating costs, project life and salvage value. For each of
these variables and/or other variables to be investigated, a frequeney distribu-
I and 2 shown
\o
() 25
:20
o
o
o15
15
't0
Ero
a6
-oo5l
(L1
o 5
o-
30
8zs
20
=
o
6
ih Figure 6-3.
't0 15 20
Rate of Return, 7o
100 Simulations
(Note multimodal maxima)
Case
25
Flate of Return,
9,o
293
'rhe
294
have initial cost of $50,000, a life of five years and zero salvage
value. There is a 40"/" probability that an improved process will be
selected with iriitial cost of $4O,OOO, a life of five years and zero salvage value. With either process there is a 50ol" probability that
annual profit will be $20,000 for the five year project life and a 25"/o
probability that the annual profits will be $15,000 or $25,000 per
year. Plot project ROR versus probability of occurrence assuming the
parameter values are independent of each other.
Solution:
The following table presents the possible combinations of different
investment costs, annual profits, probabilities of occurrence and ROR.
lnvestment
50,000
50,000
50,000
40,000
40,000
40,000
Annual
Profit
15,000
20,000
25,000
15,000
20,000
25,000
Probability of
Occurrence
(.6X.25)
(.6X.50)
(.6X.25)
(.4X.2s)
(.4X.50)
(.4X.25)
=.15
=.so
=.15
=.to
=.zo
=.10
P/Ai.s
3.334
2.500
2.000
2.667
2.000
1.600
RoR (%)
s.2
28.7
41.1
25.4
41.1
56.0
1.00
295
given in Figure 6-5. The Monte carlo simulation data are evaluated by
forming a histogram from the RoR results. For instance, if one thousand runs are
made tlren approximately tluee hundreci of the RoR rcsults ,rrorr.i bc 2g.i7o,
since we know the mathematical probability of occurrence of this resylt is .30.
In general, the variations ir.r input crata such as seiling price, oirL-raiing
cost. production rale, borrowed money interesr rete and so forth that are
evaluated will be continuous functions of cumulative probability of occurrence rather than the step functions illusrrated in Figure 6-4. Coniinuous
input data give a continuous RoR versus probabiliiy of occurrence histograrn graph for lrlonte Carlo simulation in general.
Cumulative
Probability
of
Occurrence
1.00
1.00
.80
.80
.60
.60
.44
.40
.20
.24
15,000
Initial lnvestment
Profit
(a)
(b)
25,000
Probability
of
Occurrence
.30
.20
.10
0
1.00
.80
Cumulative
Probability
of
Occurrence
.60
.40
.20
0L
0
10 20 30 40 50
60
ROR, %
296
6.5
irtcurred times the cosr. If you define cost as negative profit and keep the signs
straight, you can do as some text authors do and define expected value as the
algebraic sum of the expected valuq of each possible outcome that could
occur if the alternative is accepted. Either definition leads to the same
expected value result, which sometimes is called a "risk adjusted" result.
Several examples of expected value analysis when time value of money considerations are not relevant or significant will be presented first. Then time
value of money related examples will be illustra.ted.
Solution:
Probability of Success = 4/54
Probability of Failure = SOIS4
ExPected
Var
ue
:,?ffi,'*,T
:lffi ;;: *
-"-::l
297
. ,:,DrillingVenture
lf you spend $500,000 drilling a wildcat oil well, geologists estimate the probability of a dry hole is 0.6 with a probabiiity of 0.3 that
I
i
$2,000,000 and a probabiiity of 0.1 that the weil will produce at a rate
that will generate a $1,000,000 immediate sale value. What is the
oroject expected value?
I
{
{
,
f
il:ffi
I
I
= +$200
:;ffi ; :lT:::::H,
_ o 6(500)
or rearrangtng:
- 1.0(500) = +$200
I
I
I
i
i
I
I
tf
It
lI
I
*
Over the long run, investments of this type will prove rewarding,
but remember that the +$200,000 expected value is a statistical longterm average profit that will be realized over many repeated investments of this type. The expected value of an investment alternative is
the average profit or loss that would be realized if many investments
of this type were repeated. ln terms of Example 6-5 this means if we
dritied 100 wells of the type descrrbed, we expect statistics to begin
to work out and assuming our probabilities of occurrence are correct,
we would expect about 60 dry holes out of 100 wells with about 30
wells producing a $2,000,000 income and about 10 wells producing
a $1,000,000 income. This makes total income of $70,000,000 from
'100 wells drilled costing
a total of $50,000,000 leaving totai profit of
$20,000,000 after the costs, or profit per well of +$200,000, which is
the expected value result for Example 6-5.
Certainly if you have enough investments of this type in which to invest
and enough capital to invest, statistics are very favorable to you, and you
would expect to come out ahead over the long run if you made many investments of this type. However, if the loss of the $500,000 drilling investment
on a dry hole would break you, you would be foolish to invest in this type
298
of project because there is only a 4avo chance of success on any given try.
only if you can stick with this type of investment for many times can you
expeci statistics to work in your fuvor. This is one important reason why
most large companies and individuals carry insurance oi various types even
though in nearly all cases the expected profit from self-insuring ii positive
and therefore favorable to the company or individual. If a disaster from
fire
can break a company cr individual financially, that company cannot
afford
to self-insure. This is why insurance companies spread large policies over
many insurance companies. If disaster does strike a large poti.y holder,
the
loss will be distributed over several companies, lessening the iikelihood
of
financial disaster for any one company. It is also the r"u.on most individuals
carry fire insurance, homeowners or tenant insurance, and car insurance.
The direct financial loss or lawsuit loss potential is so great that most
of us
cannot afford to carry that risk alone even though exp-cted value is
favorable to us if we self insure. The conclusion is thit a pisitive expected
value
is a necessary br.tt not a sfficient condition
for a satisfactory iivestment.
It should now be evident that although expected value has deterministic
meaning only if many trials are performed, if we consistently follow
a decision-making strategy based on selecting projects with positive expected
values, over the long run statistics will work for us and income
should be more
than sufficient to cover costs. on the other hand, if you consistently
take the
garnbler's ruin approach and invest or bet on investments or gambling
games with negative expected values, you can rest assured that
over the
long run, income will not cover your costs and if you stick with negative
expected value investments long enough, you will of course, lose all your
capital. This is exactly the situation that exists with all of the gambling
garnes in places such as Las vegas, Reno and Atlantic city. The
odds are
alrvays favorable to rhe house, meaning the gambling housl has a positive
expected value and therefore the gambler has negative expected value.
The
gambler has absolutely no realistic hope for success over the long
run under
these negative expected value conditions. He will lose all the money
set
aside to gamble with if he sticks with the games long enough..
The reader should notice that in Example 6-5, two different, but equivalent equations were usec to calculate expected value as follows:
or
-p
= probability of failure
Cost)
(1 _ pXCost)
=(P)(Income)-(i.O)(Cost)
6-2
6-2a
6.6 Expected
Analysis
P=0.4
=$50,000 . . . . I =$50,000
1............s
P=0.6
L=0
300
9O,O0O)
- .6(90,000)
= _$14,1g4
Cash Flow.
-$90,0i,09.0)__!9900!04).. .. s0,000(0.4)
0
Risk Adjusted
Cash Ftows -$90,000
50,000(P/Ai,S)(.4)
90,000 = 0
by trial and error, "i" = Expected RoR g..ay" < i* 10% so reject
=
=
Non-risk adjusted or risk free rate of return analysis gives a
different conclusion:
302
50,000(P/A1,5)
90,000 = 0
47.60/o> i*
= 10% so accept
This result is much greater than the 10% minimum RoR indicating
very acceptable economics. As a variation of expected RoR analysis,
some people account for risk by increasing the minimum ROR by
what they consider to be an appropriate amount. The difficulty with
this approach is that there is no consistent, rational way to adjust the
minimum RoR appropriately to account for risk in different projects.
For this example, the risk free RoR is about 42.6% (based on probability of success of 1.0 instead of 0.4) compared to the expected RoR
of 3.6%. Expected RoR of 3.6% compared to risk free minimum RoR
of 1oh indicates the project is economically unsatisfactory. To get the
same conclusions based on comparison of risk free RoR and risk
adjusted minimum RoR results requires increasing the minimum
ROR to about 132% (where l1yo/3.6/" = Xl4Z.6/q therefore X
=
13:2%). A majority of people who attempt to compensate for risk by
adjusting the minimum RoR end up significantly under-compensating
for risk. For this example many peopre wilr propose increasing the
minimum RoR inversely proportional to probability of success 6to.q)
from 10"/o to 25% when as previously discussed the increase should
be from 10% to about 1go%. However, there is no way to know this
without making an expected RoR type of analysis. Expected value"
analysis using RoR, NPV or. PVR is the preferred approach to incorporate risk into economic analysis calculations.
consistent with the other criteria, the risk free pVR indicales very
rcceptable economics which is the opposite conclusion reached with
lxpected PVR.
,:
*!riril"ar
304
l=450
(c)
(D)
C=40
Times 1 and 1+ are effectively the same point in time, the end of
year 1. Normally drilling and completion time are separated by weeks
or months which puts them at the same point in time wittr annual
periods. Times 1 and 1+ are separated on the diagram to make room
for the probabilities of occurrence associated with different events.
Expected Value
1)
2['!11er
rltlsol
;;:j,]
l---
= +198.48
io.zr
i = +33.13
'
-60.87
= -219.99
-49.26
Analysis
g0
4.031
2}o/o
4.031
.8333
{[450(PiA20,eX.5) + 300(piA20,ex.ss) + zs0(n{1X. j5) _ 400](.6
.8333
40(.4)
This
4.031
.8333
.6944
+zso (p'/ F 20,z) (. 1sX. 6)
.8333
-500(P/F20,1X1 .0)
X.
4.0g1
.8933
4oopi
100 =
.ffi33
; ;;.
1 X. 6)
_ +o
.8339
pir"ll1; i: +1
-49.26
-500(1.0) 450(0.6X0.5)
-jlBIS
cF(prob
Year
) _i00(1 0)
RiskAdj
cF -1oo -zs6
?i IBBIB\Y'Y/\v'
Bi[B ?Ei
tet
450(0.6X0.s)
3oo(0 6iio 3b)
g_10
ffi
6-8
306
l=450
!=1OO
lru
P=1.0 C-
P=0.6
l=450
(A)
01
P=0.4
(D)
C=40
P=0.1 5
(c)
Salv=250
Expected Value
one.
\
- e00(PlF zo,t) + 450(P/A 20 eXp/F 20 il fo.eoy= +1e8.48
e00(P/F zo',t) + 300(p/A 2['eylerr zo. jlj tt'.z1)= +33.13
!) i-t00 - e00(Pilzo',1)
.250(piF i6',ill (c.obi"
9) f-100 = -60.87
D) [-'100 - 540(P tF zo',t)] (0 4)
= -219.99
=l'roject Expected Net Present Value (ENPV)
= _49.26
1)
t-100
Year0lzg_10
Risk Adj CF -100
zzo.s
-7s6
198
4.031
4.03.1
.8333
ZSo (p I F
20,
(. 1
1)
5)
- 4001 (. 6)
.8333
40(.4)
- s00)(p/F2},i
100 = _4s.26
This result is only slighfly less than zero compared to the total pro-
. costs of million,
ject
therefore, slightly unsatisfactory or break_
$1
even economics are indicated.
308
.-$270
P=(0.60)
-$500
P=(0.4)
(c)
P=(o.eo)
$400.
..$4oo
,......-*
(n)
P=(0.10)
$o
(B)
-$2s0
Expected Value
There are three (3) possible outcomes in this solution:
A) Successful Development, Chance Factor,
P=(0.6)(0.e) =(0.54)
p = (0.6X0.1) = (0.06)
c) Failure at Time Zero, Chance Factor, p = (0.40)
B) Failure at Year 2, Chance Factor,
Year
0. -
CF(Prob.)
Risk Adj
-270fi.q
CF -270
ENPV = -270
309
.,,
3-10
400(0.6x0.e)
-500(0.6) -2s0(0.6x0.1) 400(0.6x0.e)
201
216
-300
300(P/F1 2,1) +
201(PlFp,2)
+ 216(PlA12,g(PlFe,Z)
ENpv @
12.0o/o
= +0o17;ffiX0.e)3/8Fe122:?,,0
0.79719
250(P/F1 2,2)(0.1X0.6)
u,
0.89286
500(P/F12,1X0.6)
Solution:
Let X equal the additional cost to be incurred at time zero.
-x ^-270
P=(0.8)
400
-500
400
(A)
0
P=(0.1)
P=(0.2)
0 (c)
,!
-250
(B)
310
ENPV Approach:
arternatives wi,
always have equar net preseirt
r"ir"..
Therefore, this sorution rooks
at equating the current project
Npr;ith the Npv br tnlr"uired prob_
abilities based on the new invest*.ni,
x at time zero as forows:
477 .77 = [400(p/A
eX,g)(0.9) _ 500J(p/ F ex,i@.8)
- 250(p/F12/",2)(0.1)(0.S) _ z7O _ X
477.77 = [400(s.s2825X0.9) _
so0](0.89286)(o.B)
_ 2s0(0.7e71exo.1x0.8) _270
_X
_270_X
= 249.27
400.
.400
;; . -,
(n)
P=(0.1)
0 (c)
-250
(B)
-500(o.s)
01
-.270
400(0.72)
-250(0.08)
4oo((0.72)
0..........
268
288
10
. . .288
3..........10
ENpv = -
27
o-
400(p?F81Yji"?, + z6s@
4.9676
+ 2Eg(p / A1
ENPV = 727.02
o.7g71g
2"7",g) (p / F 1 2y",2)
/{1\ir,
,11
whether we work
with expected vaiue, expected Npv, expected pvR
or expected RoR, the
average meaning of results is similar. A common
misconception that some
people have about expected value analysis is
that it oft;n is not valid
because investors serdom repeat the same type
investments over and over.
These people have missed the basic .*p".t.d
value analysis premise that
even though each specific investment <tecision
relates to u urilr"ty different
to rank non-mutually
exciusive alternatives using risk adjusted reiults,
you must use either
expected PVR or expected Growth ROR resultr.
fo evaluate mut,ally
exclusi'e alternatives with risk adjusted results
based on any valid anarysis
technique, irlcremental analysis is the key to
correct economic decision
making. These ruies hold true even though each
investment decision rerates
to a different investment prospect with different
probabilities of success and
failure at different stages ofeich project.
312
economically satisfactory investment but not necessarily a financially satisfactory investment..small investors in the oil and gas drilling, business,usu.
ally attempt to reduce rheir financiar risk of total failure liankruptcy; by
-inteitaking a small interest in a large number of projects rather than large
ests in a few projects. This diversified investment portfolio upp.oo.h giu..
the probability of success a better chance to be realized over time as the fol-
- .tOO,OOO(.9) = +$+t0,000
and
313
ven-
tui'es can increase survival probabilities to very tolerable levels when exploration work is being done in areas where enough geological and geophysical work has been done to predict reasonable probabilities of success on any
gir cn tr).
nl
n factorial
r factorial times (n-r) factorial
r!(n-r)l
nl = n(n
at a time.
lXn
2)
----
0! =lbydefinition
P = Probability
I
Note that for Example 6-10, the probability of zero success from
c1o0r.rlor.o)'0
6.8 Risk
.ffi
l0 tries
is:
314
Levee
1
2
3
4
$120,000
.20
.10
140,000
160,000
.05
200,000
.025
$ 8o,ooo
110,000
125,000
150,000
$4,000
5,000
6,000
7,000
Solution:
Expected
Damage
Levee
Size
1
2
3
4
Annual Levee
Cost
0.1598
120,O00(A/P15,20)=19,180
Total
Annual
Expected
4,000
$39,'180
= 22,370
160,000(0.1598) = 25,570
11,000
5,000
38,370
6,250
200,000(0.1598) = 31,960
3,750
6,000
7,000
37,820
42,710
'140,000(0.1598)
Cilapter 6: Uncertainty
and Risk Analysis
J,3
{i.9
k.
i* ;#"
il:ff'J#n:::l;:f*T":nf.r:'
-
il ?:,H#ffi::"ffi;, T:#Hl
ii
[',
because
j
"r
"
pricine
"n""i
:tffi:rH::
i,
opti on p.i
g,
"i,
th
;.:;
x;3;*ti*
ar, reader
uno'
iilf
;; ;;k-schores
and
'd:l'Jii*^:'Ji:rt::l's'
ouncesorgora,RounilTf
._Tff
as a srike price) for
a specifrec p"rioo or tir.
rn9'.u,i,i;;;":r* an opdon
rs generallv limited to
a specifiLa p".iro-."r"rred
ro by;; ;;;., expirarion
dare when a ca, option
d,k";;;;;',11,
asset, rhe calt is said
price or the
to be .,in_the ,"rr.l";
The differen;;;;;;;,
value of rhe asser
the marker
r,ro. i,n* is often referred io ..inrrinsic
value'" when a call"i1.1T
as
option strike price ir'g..ur".
than the current
of an asser. the varue.of ,rr.
..our_of_the_rnoney.,market value
,il
il
be
no intrinsic varue. Ther"j".",
since it has
"pir",i'i.
,t"^";d;, based solely on specuration
future price movement.
of a
The ou..rrirur* of any
option is iefened to as a
componenrs known as inrrinsic
fl:tfr,T*JlJ,J:*"ms mav
:lT#:Iff X,!?:S;L:i::,?#*,::iil*;
g" il ;#;;#;t
r:;;
"*''i'l*"
Typically, investor
caroptioni";;;;;'J:1JxiTil:ffJ;Jr:",TTfi
,?:,",ffi
::Tfl ffi I
316
price and make a profit, if the stock price moves above the strike price.
Based on either today's prices or the most expected future prices, a patent or
mineral property may have much smaller Npv value compared to the value
based on higher potential future prices and or lower future production costs.
This potential additional value can be captured with either of two
approaches. First, a mathematical formula calted the Black scholes equation usually is used to value common stock options. Modification of the
Black-Scholes model can make it applicable to valuing patents and mineral
rights. Most people consider this approach to be very mathematically
sophisticated, and therefore, often difficult to explain and sell to management. The second approach to capturing the call option value of a patentor
mineral right type of asset is to use expected net present value (ENpv)
analysis. we have seen in previous examples that ENpv can measure both
uncertainty concerning the probability of failure and uncertainty concerning
the magnitude of a parameter and the timing when that parameter might bi
incurred.
l.
3. Traditional DCF analysis fixes the knowledge base today for determining future cash flow over the life of a project, which prohibits
accounting for large investments occurring in stages.
4. DCF analysis constrains investment timing by assuming that investments cannot be deferred, so investment decisions must be based on
today's information.
The authors of this text disagree with these perceived DCF analysis disadvantages and feel they represent misperceptions of the assumptions and
calculations upon which proper DCF analysis should be based. If you based
317
DCF analysis on the assumptions given in the four DCF disadvantage sratements, then DCF analysis would be improper and disadvantageous. Following are our rebuttals to the perceired disudvanrages:
1. Economic analyses of all types require projecting the future. Assuming today's production rates, prices and costs will stay the same over a
project life typicaliy is a very weak economic analysis assumption,
You must project the actual future production rates, product prices,
and costs by projecting escalation rates for the parameters realized
over the project life. If different future cash flow scenarios are felt to
be possible, probabilities of occurence must be projected for the different scenarios so that the cumulative probabilities equal 1.0
2. Investors dc not need to use today's dollars and probably should not
use today's dollars as the basis for most DCF analyses. Nerv project
and development or expansion options can be built into any year of an
evaluation. There is no reason to feel that DCF anaiysis precludes you
from accounting for possible future changes in production, product
prices, costs, productivity and other evaluation parameters. You must
project the future possibilities at the time you do the analysis for either'
DCF analysis or option pricing analysis. And the future assumptions
that you make will have a very significant impact on your analysis
results with either DCF analysis or the option pricing methodology.
3. DCF analysis does not have to assume that project development will
start today. With ENPV analysis you can build development and expansion into analyses over unlimited years, taking advantage of new technology and product pricing information available at different stages.
ur8
Year
Production, Units
Selling Price, $/Unit
Gross Revenue, $
Operating Costs, $
Capital Costs,
BTCF
1234
100 100 100
20 22 24
100
26
2600
800
Year
Production, Units
Selling Price, $/Unit
Gross Revenue, $
Operating Costs, $
Capital Costs,
BTCF
NPV
NPV
@
@
10% = +136
20/" = -329
1234
100 100 100
20 22 24
100
26
2600
800
800
800
800
3't9
Year
Production, Units
Selling Price, $/Unit
Gi-oss Revenue, $
Operating Costs, g
Capital Costs,
-Z4OO
_2400
BTCF
1234
100 90
20 20
90
20
1800 1800 1800
-1S00 -1800 -210O
2000
-12A0
800
90
20
300
-300
NPV @ 10o/o=-1750
NPV @ 2O/"=-1770
1234
100 130 .30
16C
22 25
Year
Production, Units
190
Seliing Price, $/Unit
35
Gross Revenue, $
220A 3250 4800 6650
Operating Costs, g
-1200 -1300 -1400 _1500
Capital Costs,
-Z3OO
BTCF
-2300 1000 1950 3400 5150
NPV @ 10"/"= +6293
NPV @ 2Oo/"= +433g
Expected
Worst
Best
136(0.6)
-1730(0.1)=-178
6293(0.3) = 1969
Expected Value
= 1797
Expected -3rr(0^6)-1r?
Worst
Best
Expected
-1770(0.1) = -1Zl
4309(0.3) = 1302
Value
g2g
320
EV = Expected Profit
Expected Cost
Examples then illustrated several approaches that could be used with equal
validity for the level of complexity presented in the textbook examples and
problems. These approaches included:
of
lr
321
lT[1j*
be
competing for limited capital. Discussion in
tt. expectei rate of return soru_
tion to Exarnple 6-6 provided further amplificatio..on
tt is topi,
For more information on these and rerated topics,
see; ,.Decision Anarysis.for?etroleum Exploration," by paul D. Newendorp,
or, ,,Mineral Exploration Decisions," by Deverle p. Harris.
PROBLBMS
A)
B) The payoff is $17 for a $1 bet on any line between two numbers
(meaning the bettor wins if either number hits).
c)
Due to uncertainty in development costs, the cost of a new manufacturing process is considered to have the following possibilities:
($)
5,000
8,000
10,000
14,000
Cost
Probability of Occurrence
0.10
0.30
0.40
0.20
l.
6-5 An initial
of
investment
S50,00i1
323
Cash
Flow
Probabilit-v of
Occurrence
$25,000
18,000
30,000
20,000
35,000
25,000
.40
.60
.50
.s0
.70
.30
of
return of l5Va.
6-6 A research
and development manager associates a probability of suc9.6) with a research investment at time zero being successful and generating the need for an additional $300,000 developcess
of
60Vo
6-7
Calculate the expecte,j net present value of a project which will cost
$70,000 at time zero, considering there is a 5OVo chance that the investment at time zero will be successful, which will require an additional
investment of $120,000 at year one. There is a70Vo chance of success
of the year one investment yielding profits over a six year period (years
2 to 7) equal to $125,000 per year. Failure at time zero will result in an
abandonment cost of $10,000 atyeat one and failure at year one will
result in a salvage value of $50,000 at year two. Should this project be
considered from an economic viewpoint if the minimum rate of return
324
What additional cost could be incurred at time zero and still give the
investor an ENPV of 2.0 (or $2,000) at time zero? Assume the additional investment in R&D or geological or geophysical work would
improve the initial probability of success.from 507o to 8-07o..reducing
the initial risk of failure at year 1 to 20Vo.
6-8 A project
6-9
'
6-10 Two alternatives are being considered for the development of an investment project. Alternative 'A' would start development now with estimated development and equipment costs of $10 million at time zero
and $20 million at yea-r one to generate net revenues of $6 million in
year one and $12 million per year uniformly at years two through l0
with a zero salvage value. Alternative 'B' would start development ttvo
years from now for estimated development and equipment costs of $15
million at year two and $30 million at year three to generate net revenues of $9 million in year three and $ 18 million per year uniformly at
years four through 12 with a zero salvage value. Use NPV Analysis for
a minimum ROR of 207o to determine the economically better alternative and verify the NPV results with PVR Analysis assuming:
A) rclEc probahility of
325
A)
Evaluate the project ROR and analyze the sensitivity of the result
to changing project life to 5 years or l5 years.
B)
CHAPTER 7
7.1 Introduction
Depreciation, depletion, and amortization are means of recovering in
before-tax dollars your investment in certain types of property used in your
trade or business, or held for the production of income. The basis upon
which depreciation, depletion, and amortization are calculated is normilly
the cost of the property, although property acquired as a gift, or in other
manners, may have a basis other than cost. The cost of buildings, machinery, equipment, and trucks are examples of business property costs that may
be recovered by depreciation over the useful life of the asset. Acquisition
costs and lease bonus costs paid for mineral rights for natural resouries
such as oil and gas, minerals, and standing timber are examples of investment property costs that may be recovered by depletion. Numerous other
business costs such as the cost of acquiring a business lease, research and
development expenses, trademark expenses, and pollution control equipment costs may be recovered by amortization. Depreciation, depletion, and
amortization all achieve essentially the same thing, that is, recovery of the
cost or other basis of investments in before-tax dollars through allowable
tax deductions over a specified period of time or over the useful life of the
investment. If depreciable property is sold, all or a portion of any extra
depreciation claimed in prior years may have to be recaptured as taxable
income. This concept is addressed in Chapter 8.
Figure 7-1 shows that the only difference between before-tax cash flow
and after-tax cash flow is state and federal income tax. To calculate income
tax, you must properly calculate taxable income. This requires reducing rev326
327
EXPANDED AFTER.TAX
CASH FLOW CALCULATION:.
Revenue
Revenue
- Operating Costs
- Dc'nreciation
:-' :-:'-""" III
uc_nietton
Operating Costs
Cal,.ita_l Costs
Income Tax
ffi:"fi?:'"" J
_:
- -i" .
non-cash
capital cosr
aeducrions
Taxable Income
Net Income
+ Depreciation
+ Depletion
+ Amortization
+ Write-offs
- Capital Expenditures
328
world country.
Tax informaiion in the following sections of this chapter and Chapter 8 is
based on U.S. Internal Revenue Service (IRS) Publication 34, the "Tax
Guide for Small Business" and IRS Publication 17, "Tax Guide for Individuals." These are free publications available by calling or writing any local
U.S. Internal Revenue Service office.
7.2 After-Thx Cash Flow in Equation Form
7-r
Alternatively, in accordance with the left column of Figure 7-1, the same
after-tax cash flow results may be obtained from calculating revenue minus
lll out-of-pocket expenditures.
After-Tax Cash Flow = Sales Revenue - Operating Costs
- Income Taxes - Capital Costs
1a
l-L
329
$24,000 for the same period. Further, capital costs totaling $29,000
for equipment are also expected to be incurred during the year. Cal.
ct.:late the anticipated project cash flow for next year.
C=$10,000
l=$1
,200
l=91 ,200
l=$1,200
L=910,000
330
CF=-$10,000
6P=$720
CF=$720
CF=$720
CF= $10'000
J^
Therefore, using Equation 3-2, since initial cost (or negative cash
flow) equals {inal salvage (or positive cash flow) the aftertax ROR is
7.24/o cotTrpared to the before-tax ROR o' 12h; a significant difference. lt is important to account for income tax considerations.
/.3
as
rpposed to those costs that must be "capitalized" and deducted for tax pur)oses over a period of time greater than a year.
331
operating cosrs that lnay be expensed include costs for direct labor,
i,tiirect labor, materials, parts and supplies used for product produced
and
cosrs associated rvith product actually .old nroy be
deducted.
This introduces the reader to the subject of working capital .rri.n
involves
drrllus tied up in prociuct inventory, spare parts inventory, accounts
receivable, required cash on hancr, etc., that are not deductible
for tax purposes
until such items are actually used up or sold, as in the case of produci
and
spare parts inventory. A more complete discussion of working
sc'ld.
only
capital and
the accounting methods that affect its value is presented in chapter g.
Some other common costs in the operating expense category
include utilities, freight and containers, borrowed money interest paiJ, royatties,
sever-
economics.
etc. Expro-
332
additional income alnount to the cost depletion basis for the property.
Recapture may be avoided by not expensing exploration charges but
instead, adding such charges to the cost depletion basis ofthe property.
drill
333
petroleum
pn-tdtrcer refnes nlore than 50,000 barrels of crude oil per day
for
average
dcily production over a year, or has retail sales of oil and gas products
exceeding $5,000,000 per year) "Integrated" petroleum producers may
onlv- expense 70vc of intangible dritling costs in the year incurred and are
reqttired to amortize the remaining 30vo of their intangible drilling costs
straight line over a five year or 60 month period beginning in the month the
costs are paid or started to be incurred. This provision does not affect the
option to expense dry hole intangible drilling costs in the year the dry hole
is incurred by both integrated and non-integrated producers. Non-integrated
producers often are rcferred to as independent producers.
7.4 Depreciation
The term depreciation is used in a number of different contexts. some
the most common are:
of
In the first context, annual taxable income is reduced by an annual depreciation deduction or allowance that reduces the annual amount of income
tax payable. The annual depreciation charge is merely a paper or ,.book,'
transaction and does not involve any expenditure of cash. In the second context, depreciation is considered to be a manufacturing cost in the same way
as labor or raw materials are out of pocket cash costs. This is a common
application of depreciation for internal company cost accounting purposes.
In the third context, depreciation is considered as a means or providing for
plant replacement. However, in rapidly changing modern industries, it is
doubtful that many plants will ever be replaced because the processes are
likely to have become obsolete during operation, so this approach is outdated. In the fourth context, a plant or a piece of equipment miy have a limited useful life, so deducting cumulative depreciation from initial value
gives a measure of the asset's falling value, usually called book value or
adjusted basis.
334
i^"-*f:.:::ed
rent
new asset.
Property is depreciable
335
2)
3.)
Ir must be something that wears out, decays, gets used up, becomes
J)
In general,
depreciable.
if property
and
it is not
7.5 Depreciationl{ethods
Depreciation of tangible properry placed in service after l9g6
is based on
using Modified Accelerared cost Recovery System (MACRS)
depreciation
for: (1) the applicable depreciation methoa, (z) ttre appticable recovery
period (depreciarion life), and (3) the applicable first y.ui^d.pr".iation
con_
depreciation methods:
1) Straight Line
2) Declining Balance
3) Declining Balance Switching to Straight Line
a greater extent
addressed.
336
Under the curent u.S. tax law, there are three applicable conventions that
have an effect on the ailowable depreciation deducti_on in the first ye3r.
These conventions apply io itre MACRS merhod, the'straight iinu'lrrrA'C(S
method (which is straight line depreciation for the recovery period allowed
by N{ACRS depreciation) and the arrernative ACRS method
iwhich applies
longer depreciation lives for straight line depreciation of special categories
of assets such as foreign tangible property or tax exempt use or bond
financed property). The recovery period begins when an asset is placed in
service under the applicable first year deduction convention. The terms
recovery period and recovery property are tax terms meaning depreciation
period and depreciable property.
Personal Property First Year Depreciation Conyentions
1. Half-Year Convention
in
First year
problems.
2. Mid-Quarter Convention
in
First year
If more than 40vo of annual depreciable property costs in a given depreciation life (recovery period) category are incurred in the last 3 months of a
tax year, the taxpayer must use the mid-quarter depreciation convention.
under the mid-quarter convention, ail property placed in service during any
quarter of a tax year is treated as placed in service at the quarter's
midpoini.
This has the effect of increasing your depreciation deduition for property
placed in service in the first two quarters of the tax year and deireasing
your deduction for property placed in service in the last two quarters.
Instead of deducting 50vo of a full year's depreciation for all p.op".ty
placed in service during the year, the mid-quarter convention gives yo,
un
87 -5vo deduction for property placed in service in the
first qu-arter (which
equals 10.5 mo-ll2mo. x 100), 62.5vo deduction for second quarrer property, 37 -5vo for third quarter property and l2.5vo for fourth quarter property.
Mid-Month Convention
For residential and non-residentiar real property the mid-month first y,ear
convention ap-plies. Under this convention, qualifying property is deemed
to
be placed in service during the middle of the monrh. irre attowaule deduc_
tion is based on the number of months the property was in service. Therefore, for a calendar tax year, assets placed in service in January of that year
would receive a first year deduction equal ro the fraction it-sttztimes the
calculated year one depreciation. Thus, one half month's cost recovery
(depreciation) is allowed for the month the property is placed in
service
with full month deductions in subsequent months.
depreciation. The faster you get depreciation tax deductions, the faster you
get the tax benefits from the deductions if income exists against
which to
use the deductions, and the better the economics of any project will
be.
Therefore, straight line depreciation is generally not desirable for tax deduc-
equation form:
(Cost)(l/n)
l_3
338
Depreciation
Yearsl
Years 2 to
Year
:($10,000)(1 t1)(1t2)
5 : (910,000X1/5)
: (910,000)(1/s)(1t2)
Cumulative Depreciation
=
:
$1,ooo
92,000
$1,ooo
910,000
Revenue
-Operating Costs
-Depreciation -
Taxable
-Tax @40"/"
Net lncome
+Depreciation
-Capital
Cost
Cash Flow
2-5
7-8
-1,000
_2,OOO _f
,OOO
3,000
339
340
",7
2-5
Year
8,000 9,000
9,000
8,000
-u,30
-800 -400
1,200
600
11,000*
-5,000
-2,000**
4,000
-800 -1,200 -1,600
1,200 1,900 2,400
2,000
3,000
Net lncome
+ Depreciation
+2,000 +1,000
+ Write-off
+2,000
Cap.
Costs
-12, 000
Cash
-12,000 +2,200 +2,600 +2,200 +1,800 +4,400
"lncludes sale value of 3,000 and revenue of 8,000
**Land working
or
capital time zero cost
DCFROR = 13.62"/" after-tax
Before-Tax ROR = 20.54%
Flow
Note that money tied up in land and working capital has a negative
effect on both the before-tax and after-tax economics of this project
when compared to Example 7-3a with no land or working capital
investment.
balance since the rate is twice the straighrline rate or, 2ln. The declining
balance rate is applied to a "declining balance" or "adjusted basis" each
year as shown in Equation 7-4.
341
7-4
Taken
7_5
The term "book value" or "tax book value" often is used interchangeably
with "adjusted basis." The terms "diminishing balance,,and ,,written down
value" have interchangeable meaning with "adjusted basis,, in canada and
Australia. All these terms represent the remaining undepreciated value of a
depreciable asset.
1
2
3
4
5
.40 x 1/2
.40
.40
.40
.40
10,000
8,000
4,800
2,880
1,729
1,037
200"/o D.B.
Depreciation
2,000
3,200
1,920
1,152
691
$8,963
Note that the adjusted basis is not fully depreciated in five years.
_
This is a problem with declining balance d'epreciation. lt literally takes
infinite years to fully depreciate a given adjusted basis with declining
balance depreciation. Switching from declining balance to straight
line depreciation enables an investor to fully depreciate an asset in
the depreciation life plus one year as shown in the next section.
342
depreciation years remain. The straight line rate of 112.5 (or 40%) for
switching in year four equals the declining balance rate of 4o/o, so
switching in year four is economically desirable (switching in year
three, the straight line rate would be 1/3.5 which is less than the
20O% DB rate ot 4O%).
Year
1
2
3
4
5
6
Method
Rate
2OO% DB to St Line
x Adjusted Basis
2OO%D.8..4000(1t2)
200"/"
200%
St.
St.
St.
D.B.
D.B.
.4000
.4000
.4000
.4000
Line
Line
Line .4OOO(1/2)
$10,000
8,000
4,900
2,890
2,990
2,990
Depreciation
$2,000
3,200
1,920
1,152
1,152
576
$10,000
343
Solution:
Units of Production
Year
,
2
$r0,000 x (14,000/50,000) =
$10,000 x (12,000/5O,O0O) =
$2,800
$2,400
344
The cost of most tangible depreciable properfy is recovered for tax purposes using the modified accelerated cost recovery system methods. Cost
and recovery methods are treated the same whether property is new or useci.
Salvage value is neglected in computing the appropriate depreciation
deduction.
5 year property inclLrdes property with an ADR class life greater than
four years and less than 10 years. Cars and light general vehicles are in this
class which also includes chemical plant assets, research and experimentation equipment, qualified technological equipment, bio-mass properties that
are small power production facilities. semi-conductor manufacturing equipment, and heavy, general purpose trucks including ore haulage trucks for
use over the road.
year property includes property with an ADR class life of l0 years but
less than l6 years. This class includes office furniture, fixtures, equipment
such as mining machinery and oil and gas producing equipment and gather7
345
includes:
refining, nranufacture
346
propefi is real property that is not (l) residential rental.property,.or.(2) property with a class.life of less ,than 27 .5
years. This class includes property that either has no ADR class life or
whose class is 27.5 years or more.
39 year non-residential real
Table 7-1 identifies the depreciation method, ADR class lives and recovery period (depreciation life) for each class ofrecovery property.
Mid-Point ADR
Period
Dqpqgglq{ion Method*
Class Lives*x
3 Yr 200Vo DB Depreciation Switching to St. Line 4 yrs or less
5 Yr 200Vo DB Depreciation Switching to St. Line 4.5 to 9.5 yrs
7 Yr 200Vo DB Depreciation Switching ro St. Line 10 to 15.5 yrs
10 Yr 200Vo DB Depreciation Switching to Sr. Line 16 to 19.5 yrs
15 Yr l50Vo DB Depreciation Switching to St. Line 20 to 24.5 yrs
20 Yr l50Vo DB Depreciation Switching to St. Line 25 or more yrs
Period
27.5 Yr
39 Yr
Depreciation Method
347
half-year convention in the first year. The rates ir] Table 7-3 are not vtlid for
personal property subject to the micl-quarter convention or lbl rcal property.
Under those cirbumstances, the reader will be required to make his or her
own depreciation calculations or refer to yeal one mid-quarter convention
rate tables published by the IRS and various accountiirg house companies.
Table 7-3 Modified ACRS Depreciation Rates*
Recovery Period is:
3
Year
Year
I
2
J
4
5
6
7
8
9
10
l1
t2
13
t4
15
16
Year
Yeat
10
Year
15
33.33
44.45
14.81
7.41
Year
20Year
7o is:
3.750
7.219
6.677
6-177
5 .7
13
5.285
4.888
4.522
4.462
4.46t
4.462
4.46r
4.462
4.461
4.462
4.461
t7
4.462
18
4.461
t9
4.462
20
4.461
2.23t
2l
* Thrr" rates times initial depreciable cost give the annual depreciation
cleductions for personal property. The 3, 5, 7 and 10 year life rates are
based on 200Vo declining balance switching to straight line with the halfconvetiiott applicable in )'ear l' The 15 and 20 year life rates are
)-ear
based on t 50Va declining balance switching to straight line with the half-
if
the mid-
Year
1
2
3
4
5
6
7
I
Method
$14,285
2t7(.5)
200% D.B.
$100,000
24,489
85,715
2/7
200% D.B.
17,493
61,226
217
200% D.B.
12,495
43,733
2/7
200% D.B.
8,925
31,238
1/3.5.
St. Line
8,925
31,238
1i3.5
St. Line
8,925
31,238
1/3.5
St. Line
4,463
31,238
1/3.5(.5)
St. Line
$100,000
Cumulative Depreciation
*The straight line rate of 1/3.5 equals the declining balance rate of
217 or 0.2857, so switching to straight line is economically desirable.
II
2a0/" DB to St Line
=
$100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
lnitial
Basis
Depreciation
$14,290
24,490
17,490
12,490
8,930
9,920
9,930
4,460
$100,000
Within round-off error accuracy, the Table 7-3 rates give the same
depreciation deductions as the declining balance switching to
sti'aight line depreciation calculations.
The mid-quarter convention applies in the first depreciation year
when assefs in a given depreciation life category whose cost
exceeds 4C% of total depreciable cosls for the year in that depreciation life category are placed in service during the final quarter of the
tax year. Cosfs for each quarter, not just the final quarter, are
affected by this convention. A half-quarter deduction is allowed in the
quarter assels are placed in service.
200% Declining Balance Switching to St. Line Depreciation With
the Mid-Quarter Convention in Year 1 and 8.
2OO% DB to Stline
Year Method Rate x Adjusted Basis = Depreciation
350
35't
or the combined equivalent of both oil and gas production using 6.000 cubic
feet of gas as equivalent to one barrel of crude oil. If independent producer
prr..duction exceeds these limits. percentage depletion may be taken on the
equivalent of 1,000 barrels per day of crude oil or 6,000,000 cubic feet of
naturai gas production prorated over total annual production.
7.7a Cost Depletion
The capitalized costs that generally go into the cost depletion basis for
petroleum and mining projects are for mineral rights acquisition and or
lease bonuses or their equivalent ascertained costs. Mining exploration costs
and petroleum intangible drilling costs may be capitalized into the cost
deptretion basis but seldom are. Cost depletion is computed by dividing the
total number of recoverable units in the deposit at the beginning of a yer
(tons, barrels, etc., determined in accordance with prevailing industry methods) into the adjusted basis of the mineral property for that year, and multiplying the resuliing rate per unit either by the number of units for v,hich
payment is received during the tax year, if you use the cash receipts and disbursements method, or by the number of units sold if you use an accrual
method of accounting. The adjusted basis is the original mineral rights
acquisition or lease cost plus any additional costs capitalized into the cost
depletion basis (such as mining exploration or petroleum drilling costs) for
the mineral property, less the total depletion previously allowed or allowable over the life of the property. The depletion allowed or allowable each
year is either percentage depletion or cost depletion as discussed in the following pages. The adjusted basis for cost depletion calculations can never
be less than zero. In equationfornt cost depletion equals:
(Adjusted BasisX
Cumulative Depletion
Mineral rights acquisitiott, lease bonuses, and otlter equivalent ascertained costs, including geological and geophysical survey costs, and
recording, legal and assessment costs, nornlally are the primary costs that
go into the cost depletiort adjusted bosis. The IRS permits most other capital costs to be depreciated or amortized and companies generally do not put
any costs in the cost depletion basis that are not required to be put there
because percent depletion can be taken even if the cost depletion basis is
zero. This means that you normally want to deduct every capital cost possi-
352
ble by a means other than cost depletion because you still get percentage
depletion which is usually larger than cost depretion anyway. Integrated oil
and gas producers have lost this benefit since they are no longer eligible for
percentage depletion on revenue from oil and gas production. However, all
types of mining operations get the larger of allowed percentage or cost
depletion on mining mineral revenue.
Solution:
Year 1:Cost Depletion = ($1S0,000X
50,000 barrels
1,000,000 barrels
= 97,500
Year 2: Cost Depletion = (9150,000
$7,500X
50,000 barrels
950,000 barrels
= $7,500
cost depletion, the cost depletion basis for year two would be the
year one basis minus year one percentage depletion. This is illustrated in Example 7-9.
7.7b PercentageDepletion
Percentage depletion is a specified percentage of gross income after royalties front the sale of ruinerals removed from the mineral property during
tlle lax ),ear. Hovveve4 the deduction for depletion under this method catxnot
353
i soqo @r l}ovo)
of taxable income, you are allowed to take 507a (or lCf,vc) of the
taxable
;n.ome before depre tion as your percenrage depletion deduction. (There
is
*.r lirnitation on the maximum annual cost depLdon that can be
taken in a
given year, except tirat the accrued cost deplition cannot
exceed the cost
basis of the prope(y.) However, unrike depreciation and
cost depletion, per-
Percent
Depletion
\
\
.,.
,--)
'Allowed Percent
Depletion"
'Allowed Depletion"
on the Investor's
Tax Return
Limit on Percent
Depletion
Cost Depletion
354
Mineral Deposits
15
andmineralsincludingbauxite
........22
ore,oilshale,andgeothermailiquidsorvapor ...... 15
Coal**, lignite and sodium chloride
. . . . l0
Clay and shale used in making sewer pipe, bricks, or used
as sintered or burned lightweight aggregates.
. .7 yz
ores.
. . . . 14
l1 Int"g.uted petroleum producers are not eligible for percentage depletion. 2) The fixed contract pre 2fir75 natural gur p"r""ni depletion rate is
227o.3) stripper well (less than 15 barrels per day ur'"rug" production)
depletion is increased l%o for each $1.00 per barrel that the average
annual crude oil price is less than $20.00 per barrel, subject to a maxi_
mtrm lAVo rate increase from l5%o to 25Va.
*] rn" percentage
depletion rates for coal and iron ore drop to gvo and,
72vo respectively after the cost depletion adjusted basis has been recovered by allowed percent or cost depletion deductions.
i)5
T'he percentage
6;;uni
Solution:
owners get percentage depretion
on royarty revenues and
- -Royalty
pay
severance tax on royarty revenues
so we can base the anarysis
on net revenues after royalties.
356
Year
'
: !qpl99!e!9!
$1,450,000
:190,0Q0
-30,000
-120,000
1,120,000
1,120,000*
-217,500
7,500
902,500
Taxable lncome
- Tax @ 40%
-361,000
541,500
120,000
217,500
t_e9p!9!9!_rakel:
$ 879,000
357
Solution:
Since silver is a 15% depletion rate minerar whire read and zinc are
$1,500,000
-700,000
-100,000
-220,000 | select
-75,000 J ZgS,OOO
Taxable lncome
700,000
350,000
-..p*
7.8 Amortization
It is permissible for a business to deduct each year as amortization a proportionate part of certain capital expenditures. Amortization permits the
recovery of these expenditures in a manner similar to straight line depreciation over five years or a different specified life. As a general rule, amortization relates to intangible asset ccsts while depreciation relates to tangible asset
costs. Howevcr, only certain specified expenditures may be amortized for federal income tax purposes.
A corporation's organization
358
Solution:
359
Year
AmortizationDeductions
0
1-4
5
revenue
360
llol tax dcductibie by ttre lender nor is it taxable income to the borrorver. All
income from the propefiy including the value of production payments, is
taxable income to the owner of the property working interest and that owner
is entitled to the applicable mineral depletion allowance..,The..owner.of the
production payment is not entitled to depletion on that amount.
In the process of calculating mineral project cash flow, the first items
deducted from applicable mineral sale revenues are the royalty costs
because in most instances, royalty owners are allowed to take depletion on
royalty revenues. Therefore, the investors in mining or petroleum properties
only get to take percentage depletion (when applicable for oil and gas) on
the net revenue after royalties which in the oil industry is often referred to
as the 'net revenue interest.' Landowner royalties vary with different mineral industries. In oil and gas, thb standard royalty is 1/8 or l2.5va of the
gross value of the product extracted from the property and may include an
up fiont fee on a dollar per acre basis, this fee is sometimes referred to as a
lease bonus or rental and generally goes into the cost depletion basis for a
lease. An overriding royalty or caried interest is similar to a landowner's
royalty and is subject to the same percentage depletion considerations. participating interests also previously defined as net revenue interests and
working interests may change over a project life, but they too represent an
economic interest in the property and are subject to applicable percentage
depletion considerations. on the other hand, percentage depletion is not
allorved for lease bonuses, advanced royalty payments, or any other amount
payable without regard to actual production of minerals. only cost depletion is applicable in rhis situation.
resources from the land and is based on the value or quantity of production.
Severance taxes are also defined as mining taxes, excise tax or a net proceeds tax dependent upon each states unique wording. However, the tax is
alu'ays based on actual production or output value of either oil and gas or
rnining minerals and tirnber. Severance taxes usually are calculated on a flat
resource extracted.
ofren paid in
351
of all the
resource property taxes, rol'alties, and production payments goes
'arious
well
beyond the objectives of this textbook. In all evaluation situations,
the
investor's tax position rnust be carefully considered with appropriate
tax
personnel or material to determine the rlsulting tax benefits
and liabilities
or obligations of each investor.
7.10 Four Investor Financiar situations That Affect cash Frow
All investors whether individual, corporate or government, fall into one
of four financial situations for cash flow calculation purposes. The four
uation the new project is credited with tax savings from the operating
expenses and deductions in the year incurred. This assumes
the new project
deductions are "deducted" against other income in the year
deductions
are
362
BeJbre-I-ax An investor is a tax-free entity such as a government or charitable organization that is not required to pay any federal or state jncome
taxes on revenues associated with investments. Therefore, before-tax analysis of project investment is appropriate.
If other income exists against which to use deductions from new projects,
the investor realizes the tax benefits more quickly than when other income
does not exist and negative taxable income must be carried forward. The economics of projects will always look better for investors who have other income
against which to use deductions when incurred, compared to an investor that
does not have other income. Tilx savings are inflows of money, and the faster
they are rcalized, the better project economics look. Therefore, it is very
important to analyze the economic potential of projects from the viewpoint oi
the financial situation of the investor. This is true in all industries and countries. It is incorrect to carry negative taxable income forward in an analysis if
other taxable income exists, and it also is incorrect to credit a project with tax
savings from negative taxable income in any year if the invesior is in a financial situation that requires carrying negative iaxable income forward.
In this text, examples and problems in chapter 7 are presented primarily
-from
the viewpoint of investors who must carry negative taxable income
forward using "stand alone" economics described earlier in this section.
Chapter 8 illustrates analyses from both the viewpoints of ,,stand alone,, and
"expense" economics. chapters 9 and l0 emphasize analyses from
the
viewpoint of investors that have other income against which to use deductions, so the "expense" economic analysis financial assumption is emphasized. The next example illustrates carrying negative taxaLle income forward using the "stand alone" financial assumption.
,r.t
Solution:
(A) Corporate Mining Anatysis
1,000,000;;its
in;;;rve
x ($2,000,000
9720,000) = $320,000
364
Year 0
Year
Sales Revenue
- Royalties @ 20%
Net Revenue
- Operating Costs
- Development
- Depreciation
- Amortization
Year 2
6,000,000
-1,200,000
6,900,000
-1,360,000
4,900,000
-700,000
5,440,000
-900,000
-142,900
-49,000
-244,900
*49,000
3,909,100
1,954,550
4,347,100
2,173,55A
-720,000"
-916,000.
-560,000
-24,000
-594,000
Net lncome
+ Depreciation
+ Depletion
+ Amortization
+ Loss Forward
- Capital Costs
-594,000
400,000
320,000
__qry,ogq
_2,605,100
3,531 ,100
-1,042,040
-J,412440
1,563,060
142,900
720,000
49,000
594,000
2,'1'19,660
24,000
244,900
916,000
49,000
-:,elgpgq".
Cash Flow
-$3,800,000
$3,057,960
$3,227,560
CF = -560,000
7_2
3,Z4O,OO0 = -$3,g00,000
r 2 CF = 6,800,000
Gives the
,O4Z,O4O= $3,057,960
365
x ($2,000,000
Year 0
Year
Sales Revenue
- Royalties @ 20%
Net Revenue
- Operating Costs
- IDC
-
Depreciation
Amortization
Cost Depletion
Loss Forward
Year 2
6,000,000
-_l_,?qqpgq
:1,39qp9q
4,900,000
-700,000
5,440,000
-900,000
-142,900
-49,000
-400,000
-594,000
-244,900
-49,000
-400,000
2',925,100
3,947]00
-1,tlgp+o
-1,579,940
2,368,260
244,900
400,000
49,000
6,800,000
-560,000
-ro,ooo
Taxable Income
-Tax @ 40%
-584,000
Net lncome
+ Depreciation
+ Depletion
+ Amortization
+ Loss Forward
- Capital Costs
-594,000
Cash Flow
$400,000) = 9400,000
24,000
1,755,060
142,900
400,000
49,000
594,000
-:;rq,ogg-.
-$3,900,000
$2,929,960 $3,061,160
366
- 3,Z4O,OO0 = -$3,8001000..
Yr 1 CF = 6,000,000 - 1,200,000 - 700,000 - 1,1 7O,O4O $2,g29,g60
=
Yr 2 CF = 6,800,000 - 1,360,000 - 800,000 1,SZB,B40 $3,061,160
=
7.ll
Summary
Method of Deduction
Operating Costs
All investors
All investors
All investors
Royalties
Taxes
State Income Thxes
Severance
Research
Develop
Mine Development
Experimental
All
All
lntangible Drilling
costs
3uildings (Real
Prop.)
{uipment
(Personal
Prop.)
27 .5
rs,
Mid-Month
in Thble 7-3.
Description
367
Method of Deduction
intangible Assets (goodwill, For all investors, amoftize over the appropriate
patents, copyrights. etc.)
life, which varies in accordance with the asset
and tax code. For example, the acquisition of
exclusive rights to a patent would be amortized over the remaining life of the patent.
Goodrvill is amortized over l5 years.
Working Capital
Common Stock
Depletion
Percentage Depletion
(Adj Basis)(
Basis
Yr
in mining or a
100Vo
gas.
368
taken.
369
PROBLEMS
7'l
Equipment (such as oil and gas producing equipment, mining machinery- or certain general industry r'quipment) has been purchased and put
into service for a $2,000,000 cost. calculare the N{ACRS dep:eciarion
(20avo declining balance swirching to straight line), and straight line
depreciation per year, for a7 year depreciation life, u,ith the half year
I convention applicable for both methods, assuming the equipment is
put in service in year 1.
'
7-3 A company
7-4
7-5
Mineral rights to a petroleum property have been acquired by a company for a $500,000 lease bonus fee at time zero. To develop the propefty, estimated time zero capital expenditures include intangible drilling
370
A)
inaepenoent
petroleum company with less than 1,000
bbviay crude production.
B)
by
a
company for a $500,000 bonus cost at
time zero. A mineral develop_
ment cost of $2,000,000 and mine equipment
cost of $1,000,000 will
be incurred at time zero. year one production
wil be 200,000 tons of
ore from initial reserves estimated to be 1,000,000
tons of ore, with
net smelter return value of the ore estimated
to be $ 1g dollars per ton.
Royalties are r6,a of gross income. operating
in year I
de'elopment cost at time zero. Deduct the
remainin g 3ovo by amorti_
zation with a six month (6/60) deduction
at time zero. Assume a40vo
effective income tax rate and determine
the estimated cash flow during
time zero and year one fbr a corporation,
assuming ,.stand arone,, ross
carry forward economic analysis.
7-"7 A minerar reserve containing 100,000
tons of gold ore is to be devel_
oped and produced uniformly (20,000 tons
fer year) over years I
through 5 by a corporate investor. The estimated
net smelter return
value of the ore is $120 per ton in year
l, and the net smelter return is
expected to increase $ 15 per ton in each
following year. Royarties are
57o of gross income. A one_time mineral
development cost of $900,000
371
7-8
372
ton reserve.
The time ze.ro mineral rights acquisition cost of $2,000,000 is the basis
for cost depletion. Development expenses of $1,500,000 will be
A)
The investor is a corporation. Expense 70va of mineral development in time zero. capitalize the other 3ovo and deduct by amortization over 60 months assuming a six month deduction (6/60) in
time zero.
Bj
The investor is an individual. Expense ro\vo of mineral development cost in time zero.
in vear one and be depreciated using the 7 year life MACRS depreciation with the half-year convention (the half-year convenfion is
included in the Table 7-3 rates), beginning in year one. production is
estimated to be 350,000 barrels per year, starting in year one. wellhead crude oil value before transportation costs is estimated to be
$22.00 per barrel in year one, $23.00 per barrel in year two, and
$24.00 per barrel in year three. Royalties are ro.ovo of revenues (well-
373
A)
B)
The invesror is an independent producer with ress than 1,000 barrels per- day average procluction. Expense r00vo of intangible
drilling costs in time zero; the larger of percentage (subject to'the
1007c limit) and cost depletion is allowed on production up to
1,000 barrels per day. To simplify the calculations, assume all production would qualify fbr percentage depletion.
c)
The investor is an independent producer with more than 1,000 barrels per day. Expense 1007o of intangible drilling costs in time
zero; only cost depletion is allowed on incremental production
above 1.000 barrels per day.
7-11 Petroleum mineral rights have been acquired at time zero for a lease
bonus of $200.000. A well is projected to be drilled and complered ar
time zero for an intangible drilling cost (IDC) of $500,000 and tangible producing equipment cosring $400,000. The tangibre producing
equipment is depreciable over 7 years using modified ACRS depreciation starting in year one, rvith the half year convention. Gross oil
income is expected to be $700,000 in year one, $600,000 in year two,
$500,000 in year three. $400.000 in year four and $300,000 in year
five. Royalties total 15.\vo of gross revenues each year (for a net revenue interest of 85.07o). operating costs are estimated to be $50,000
per year in each of years one through five. Depletable oil reserves are
estimated to be 200,000 barrels with 30.000 barrels produced in year
one, 27,000 barrels in year trvo, 24,000 in year three,21,000 barrels in
374
year four and 18,000 in year five. Assume no other income exists so
all negative taxable income will be carried forward and used against
project taxable income (stand alone economics). use a 4o.0vo t'ax rate
and calculate the cash flows for each of years 0 through 5. Deduct
write-off's on remaining tax book values at year 5, when a sale value
of $250,000 is received. Determine the project DCFROR for:
.
A) An integrated petroleum
1,000 barrels per day of crude oil production, ,o eligible for either
percentage or cost depletion and who may expense t\ovo of IDC's
in time zero.
barrels per day of crude oil production, so eligible only for cost
depletion, but may expense l00Vo ofIDC's in time zero.
year five.
2)
376
ordinary income. Calculate the annual after-tax project cash flows and
determine the DCFROR and NPV for an investor desiring an escalated
dollar after-tax minimum rate of return of l2%o.
7-15 Using the data in problem 7-14
A)
following:
B)
C)
oil and gas company with existing production in excess of i,000 bpd. The company is considering this to be an oil & gas project that required an additional time
zero expenditure of $5,000,000 in petroleum intangible drilling
Suppose this was a non-integrated
377
costs. FLrrther, assurne the land acquisition cost was really a lease
A man invests
CHAPTER 8
8.1
Introduction
The objective of this chapter is to relate income tax effects, working capital and the concep't of cash flow to discounted cash flow analysis as it relates
to rate of return, net value analysis and ratio decision criteria applied after
tax considerations. After-tax rate of return analysis commonly is referred to
as Discounted Cash Flow Rate of Return or DCFROR analysis. Other names
given to this method in the literature and textbooks are Profitability Index or
P.I., Investor's Rate of Return, True Rate of Return and Internal Rate of
Return. All of these names refer to the same method which easily is the most
widely used economic analysis decision method in practice, even though Net
Present Value and Ratios have advantages over DCFROR in certain analysis
situations described in earlier chapters.
The effects of income tax considerations often vary widely from one investment alternative to another, so it generally is imperative to compare the relative
economics of investment altematives on an after-tax basis to have a valid economic analysis. Income taxes, both federal and state if applicable, are prcject
costs, just as labor, materials, utilities, property taxes, borrowed money interest, insurance and so fbrth are project operating costs. It does not make sense
to leave income taxes out of an analysis any more than it would make sense to
omit labor, materials or any other operating cost from an analysis.
As described in Chapter 7, cash flow is what is left from sales revenue
each year after paying all the out-of-pocket expenses for operating costs,
capital costs and income taxes. All tax deductible expenses, except income
taxes, are put into the operating cost category and capital costs, such as
building and equipment costs, are deductible over a period of time greater
chapter B: lncome Tax. working capitar, and Discounted cash Frow Anarysis
379
380
Every taxpayer must compute his or her taxable income and file an
income tax return on the basis of a period of time called a tax year. Beginning in 1987, for all taxpayers except regular "c" corporations, a tax year is
the 12 consecutive months in the calendar year ending December 31. A fiscal year for "c" corporations is 12 consecutive months ending on the last
day of any month, as specified by corporation by-laws.
.
larv phase out of certain itemized tax deductions and personal and dependency
exemptions. For example, a marieci couple filing a joint retum for 2000 must
reduce their itemized deductions by an amount equal to 3.\va of the difference
between their adjusted gross income and $129,950. This in effect increases the
marginal tax rate by 1.197o, making the top rate 40.79vc or higher. If a married
couple files a joint return and has adjusred gross income above $193,400 their
personal and dependency exemptions of$2,550 per person in 2000 zue phased
out at a rate of 2.07a of exemptions lost for every $2,500 income rises. This is
equivalent to an effective increase in the marginal tax rate of 0.glra for each
exemption. currently for a married ccuple with two children the phase out of
iternized deduction and exemption deductions makes the upper limit tax rate
44.037o, and with more exemptions it would be higher.
Frolry Anarysis
381
1\[arried Taxpayers:
If ?00n raxable income is:
43,8-50
11,850
of Taxirble Incorne
$6.578 + 287o ofErcess over $43,850
$21,966 + 3lVo ofExcess over g105,950
$41,171 + 36Vo of Excess over $161,450
$86,855 + 39.67a of Excess over g288,350
157a
$ 105,9-50
$i0-i,9s0 $161,450
$i6i,.450 $288,350
$28S,350
and up
Single Taxpayer:
$
$
- o
26,250
63,550
$132,600
$288,350
63,550
$132,600
$2gg,350
and up
All of the above income brackets are applicable for the year 2000 and will
be adjusted each subsequent year for inflation as meaiured by the consumer Price Index (CPI) for the 12 month period ending August 3l of the
previous year.
Other relevant information as of 2000:
Standard deduction fbr marieds is $7,3-50
Standard deduction for singles is $4,400
382
$
$
$
$
$
tax is:
- The
15Vo of taxable income
$ 50,000
50,000 $ 75,000 $7,500 +257o ofexcessover$50,000
75,000 $ 100,000 $13,750 +34Zoofexcessover$75,000
100,000 $ 335,000 $22,250 + 39Vo of excess over $100,000
-0
Thxable income is not adjusted for inflation each year in the manner that
individual taxable income brackets are adjusted.
$100,000 must pay an additional tax equal to 5vo of the amount in excess of
$100,000, up to a maximum additional tax of $11,750. This extra tax operates
to phase out the benefits of graduated rates for corporations with taxable
incomes between $100,000 and $335,000 and causes the effective federal corporate tax rate to be 397o (34vo + 5vo) on the increment of taxable income
Chapter 8: lncome Tax, Working Capital, and Discounted Cash Flow Analysis
383
in most states, so the overall effective federal plus state tax rate will be greater
thin 35Vo for corporations or the appropnate incremental federal rate fbr individLrals. Usuaily the effective rate will be in the range of 35Vc to 407o for corporations, or 30 to 457o for individuals, as will be developed in Section 8.7.
1t
jt.
from the sale is considered a shortterm gain or loss. Short-term gains are treated like ordinary income. If the
same asset is held longer than one year, the gain or loss is considered longterm gain and for individuals, usually taxed at the lower capital gains rate of
20.0Vo. However, persons in the l5.0%o ordinary income tax bracket have
capital gains taxed at l0.0Vo. Beginning January 1,2001, taxpayers in the
15.}Vc tax bracket will also see their capital gains rate fall from l0.0Vo to 8.0Vc
for assets held for five years or more including assets bought before January 1,
2001. For individuals in the 28.0Vo or higher ordinary income tax brackets, the
long-term capital gain tax rate drops from 20.0Vo to l8.0%o for investments
made after January 1, 2001 and held for a period of five years.
For all individuals, capital gain due to depreciation taken on real property
(residential rental or commercial property) is taxed at a 25.UVa rate.
Short-term capital gains and losses are merged by adding the gains and
losses separately and subtracting one total from the other to determine the
net short-term capital gain or loss. Sirrrilarly, long-term capital gains and
losses are merged to determine the net long-term capital gain or loss. The
total net short or long-term capital gain or loss is then determined by merging the net short-term capital gain or loss with the net long-term capital gain
or losses in accordance with tax return procedures.
Corporations may only deduct capital losses to the extent of capital gains.
Individuals may deduct capital losses from ordinary income up to a maximum of $3,000 per year with the balance carried forward for future years.
This includes both long-term and short-term losses.
384
An individual investor with $200,000 of annual taxable income purchased a parcel of land 3 months ago for $5O,OO0 and now has an
offer to sell it for $60,000. Neglecting the time value of money, what
selling price after owning the land 12 months plus one day will give
the investor the same after-tax profit as the $60,000 selling price
now? Evaluate this problem from the standpoint of an individual
whose ordinary federal income tax rate on the incremental income
would be 36% and state tax rate zero (.as in Texas and Alaska).
Solution:
lf the property is sold now, short term capital gain tax is:
- lncome Tax
$6,400 = X-50,000 - (X-50,000)(0.20)
Profit = Gain
8.5
or equipment
is sold by indi,-iduals or corporations, the sale value (terminal value) is
cornpared to original cost, or remaining tax book value of depreciable,
depletable, amortizable or non-deductible asset costs to determine gain or
loss. If the sale results in a gain, tax must be paid on the gain. If the sale
results in a loss, the loss is deductible under the tax rules governing the
handling of ordinary deductions and capital loss deductions. As we showed
Chapter 8: lncome Tax, Working Capital, and Discounted Cash Flow Analysis
eai-lier, all long rerm cilpital sains are taxed at the ordinary income tax rates
tbr colporat.ions and at a2}.ovo capital gains tax rate for individuals, so it is
strll necessary to compute whether ordinary gain or loss, or long term capital sain or loss is realized. If a loss results from the sale, the investor is eligihie for either an ordinary income cleduction 'uvrite-t-ifr or a long term capitai krss deduction write-off, again depending on the type of asset involved
and the tax position of the investor. Although corporations have cctpital
gain incorne taxed as ordinary income, corporate capital losses can only be
userl against capital gains or carried.forward.
when either depreciable or non-depreciable property has been herd for
more than one year and sale value exceeds original cost, the increase in the
value of property (difference in sale value and original cost) usually is
treated as a long term capital gain. For individuals, any gain due to depreciation of personal property is treated as ordinary income. Accountants often
refer to the tax on the gain due to depreciation as "recapturing deprebiation."
Since the deductions sheltered ordinary income, and were .taken in an
amount in excess of the current value of the asset, that component of a sale
between the original purchase price and final book value is taxed at the same
orriinary income tax rate. one exception is real property, where as mentioned
in Section 8.4; for individuals, gain due to depreciation of real property (such
as rental property) is currently taxed at a25.07o capital gain tax rate when
straight line depreciation is utilized.
386
Solution:
Al)
Year
Revenue
- Book Value
180,000
-100,000
Thxable lncome
- Tax @ 35%
-28,000
Net lncome
+ Book Value
- Capital Cost
52,000
100,000
0
ATCF
80,000
-100,000
100,000
152,000
YearOlZ
Revenue
- Book Value
180,000
-100,000
Taxable lncome
- Tax @ 20%
-16,000
Net lncome
+ Book Value
- Capital Cost
64,000
100,000
0
ATCF
80,000
-100,000
-100,000
DCFROR, i = 28.1"/"
164,000
I
I
$
I
t
:
Bl)
00,000
$20,000 = $g0,000
Year
Revenue
- Depreciation
- Book Value Write-off
Taxable lncome
- Tax @ 35/"
Net lncome
+ Depreciation
+ Book Value
- Capital Cost
ATCF
190,000
-20,000
-80,000
-20,000
7,000
-13,000
20,000
100,000
-35,000
65,000
80,000
0
-100,000
0
7,000 145,000
-100,000
PW Eq: 0 =-100,000 +7,000(p/F;,1) + 14S,OOO(p/Fi,2)
DCFROR, i = 24.0"/"
Since the corporate tax rate is the same for both long-term capital
gain and ordinary income, the difference in the sale valu6
and remaining tax book value represents the total taxable income as
shown in
y.ear 2- This simplified approach may not be
applicable for individuals
due to the reduced tax rate associated with long-term capital gain
resulting from the increase in the asset value comp=ared to
the orig-inal
purchase price. This is illustrated in Case 82.
388
-100,000
157,000
Note: ln year 2, $100,000 of additional revenue equal to the initial
cost has been added in the next to last column. This same amount
is then subtracted as the initial cost basis in the final columh. These
amounts cancel leaving $180,000 of sale revenue to be considered.
The year 2 sum of the two after-tax cash flows is g157,000 which
can be reconciled by taking the revenue minus cumulative tax, or;
$180,000 - $7,000 - g16,000 = $157,000
PW Eq: 0 = -100,000 + 7,000(plFi,1) + 157,000(plFi,2)
DCFROR, i = 28.9oh
Chapter 8: lncome Tax, Working Capital, and Di.scounted Cash Flow Analysis
Year 1
Depreciation:
9100,000(1/39)(5.Si 12) = $1 ,1 75
Cumulative Depreciation Taken
- $1 ,175
Year 2 Write-off (or book value deduction):
$100,000 - $1,175 = $98,825
Year
Revenue
- Depreciation
- Book Value Write-off
-1,175
Taxable lncome
- Tax @ 35%
-1,175
Net lncome
+ Depreciation
+ Book Value
- Capital Cost
ATCF
190,000
411
-764
-98,925
81,175
-28,411
52,764
1,175
98,825
-100,000
-100,000
411
0
1
51 ,5gg
390
to
Year
100,000
Revenue
- Depreciation
- Book Value Write-off
-1,175
Taxable lncome
-1,175
- Tax @ 35% (ordinary gain)
:"
- Tax @ 25% (deprec. gain)
- Thx @ 20% (long-term gain)
Net lncome
+ Depreciation
+ Book Value
- Capital Cost
-gg,g25
1,175
180,000
-100,000
80,000
-294
-16,000
-764
88'1
64,000
98,825
0
1,175
-100,000
ATCF
64,000
163,706
Note: Once again, in year 2, the sum of the two cash flows is
$163,706 which can be reconciled by taking the revenue minus
cumulative tax paid that year, or;
$180,000
$29+
$1
6,000 = $163,706
Chapter 8: lncome Tax, Working Capltal, and Discounted Cash Flow Analysis
8.6 Alternative
391
Calculation
Revenue
- Operating Costs
- Depreciation
- Depletion
- Amortization
- State Income
Tax
of Federal Taxable
Income = Regular Federal
Income Tax on Corporate
Taxable Income Above $10
Million.
35Vo
The starting basis for AMT is regular federal taxable income from all
A number of "adjustments" and "preferences" are taken to regular federal taxable income to determine alternative minimum taxable
income (AMTI), which is then taxed at 20.0Vo for corporations. The AMT
rates for individuals are 26.0Vo on AMTI up to $175,000 and 28.0Vo on
sources.
392
AMTI in excess of $175,000. AMTI taken times the appropriate AMT tax
rate gives tentative minimum tax (TMT). Finally, the difference betwee4 the
TMT and'the regular federal tax iiability is thb taxpiyer AMr for a given
year, which if positive, is paid in addition to the regular tax, if any. , ,,
A partial list of corporate 'AMT Adjustments?' includes; depreciation on
assets place into service after 1986 and prior to 1999, mine exploration and
development costs, long-term contracts (percentage of completion accountins inetirodology must be used), amortization of pollution control facilities,
certain installment sales, and the alcohol tuels credits.
An 'AMT adjustment" is defined as the yearly difference between the regular tax deduction for a given expenditure and its allowed deduction under
AMT rules. As an example, mining development costs are 70vo expensed
and 3avc amortized over 60 months for regular tax purposes, but these costs
must be deducted straight line over 10 years for AMT purposes. Therefore,
in the first year of such expenditures, AMTI wilr increase, but in later years,
the adjustrnent will reduce the AMTI exposure for that expenditure. The
ANIT adjustment on mining development costs can be avoided by using
straight-line, 10 year life amortization deductions for regular tax purposes.
Unlike adjustments, 'AMT Preferences" (also known as Thx preference
Items (TPIs) always increase the amount of AMTI. corporate Tax prefer
ence Items include but are not limited to; mining percentage depletion that
exceeds the cost depletion adjusted basis for a property, integrated
pctroleum producer intangible drilling costs (IDCs), tax exempt interest on
certain bonds and reserves for losses on bad debts of financial institutions.
A inte-trated oil and gas company can avoid the Tax preference Item for
IDCs by amortizing all IDCs over 60 months for regular federal income tax
purposes
I*
Chapter 8: lncome Tax, Working Capital, and Discounted Cash Flow Analysis
393
I
It
*
Ii
i
$
I
I
I
fi
t.
ner similar to other loss forw'ard deductions, except that the Alternative
NoL is reduced by alt tax preference items and tax items that must
adjusted for
be
AMTI. This deduction may not offset more than govo of AMTI
AMT is expensive not only in terms of the additional tax burden it presents, bnt also because of the effort required to calculate the tax each year.
corporations must norv maintain several sets of books to account for the
regular federal income tax, shareholder financial reporting, adjusted current
earnings, AMT and other business transactions. For some investors, the cost
of monitoring the AMT calculations may exceed the resulting tentative minimum tax payment.
subchapter S corporations, partnerships, real estate mortgage investment
conduits (REMICs) and foreign corporations (excluding their income from
u.S. business) are exempt from AMT. However, income from these entities
t.
394
i.s
federal income tax and AMT. All other corporations and individuals with
income must also compute AMT yearly. Thlrefore, it is necessary to consider the impact of AMT on investments and project.evaluations
but given
the complexity, usually this tax is negrected unless the investor is assured
of
a long-term exposure to AMT. As previously mentioned, in such cases
the
tax rates reflect applicable AMT rates and deductions are modified to
on a long run basis, due to the Minimum Tax
credit, AMT should not result in additional tax being paid, it simply is a
timing issue that each investor must address individually as to its signifireduce the exposure to AMT.
8.7 Effective
f(l-s)
g_l
Solution:
Using Equation B-1:
Effective Corporate Tax Rate = 0.06 + 0.34(t_.06)
= .3796 or 57.96"/"
Total Tax Due = $120,000(0.3796) = $45,552
395
The same resurt courd be obtained without the use of the effective
tax rate as follows:
StateTax
Total
6.8
=$120,000(0.06)
Tax
=$7,200
= $Sg,OSe
$45SS,
Tax Credits
ra.Tvo
396
full rehabilitation credit. Refer to a tax manual for specific tax rules that
describe qualified rehabilitation costs.
Alternative Fuels credit. A tax credit is allowed for the domestic production bf oil, gas, and synthetic fuels derived from non-conventional
sources (such as shale, tar sands, coal seams, and geopressured brine) that
are sold tq non-related persons. The credit is claimed by attaching a separaie schedule to the tax return showing how the credit was computed. The
credit is generally $3 per 5.8 million BTUs (energy equivalent of one barrel
of oil) produced and sold from facilities placed in service after 1979 and
before 1993, or from wells drilled after 1979 and before 1993. Such fuels
must be sold before 2003. The time period is extended for certain facilities
subject to a written binding contract in effect before 1996. The credit is
phased out as the average wellhead price of uncontrolled domestic oil rises
fr.m $23.50 to $29.50 per barrel. The credit and phase-out range are
adjusted tor inflation.
Tax credits from all sources are credits against your regular tax bill and
not cleductions fi'om tarable income, sttch as depreciation. A dollar of to.r
credit saves a dollar o.f tax cost, vvhile a dollar of depreciation saves onl-t
tlrc tax rate tintes a dollar in tax cost. Howeve4 tax credits carutot be used
to reduce AMT.
Tax credits
the
Depreciation Effects
chapter B: lncome Tax, woi'king capitar, and Drscounred cash Frow Anarysis
40% effective income tax rate and calculate the annual revenue cash
ilow for the year assuming: case 1) no depreciation deduction or tax
credits are applicable; case 2) annual depreciation is 9100,000 with
no tax credits applicable; Case 3) annual depreciation is zero with a
$100,000 tax crecjit appircable. Also caicuiate the maximum tax credit
that could be utiiized in the case 3 project evaluation year.
-Depreciation
Thxable lncome
-Tax @40"/"
+Tax Credit
j
1i
1i
{
,,
'l
Case
Case O
Deprec.
$100
$100 Tax Credit
No Tax Credit and No Deprec.
500
-Y
500
-1 50
-1 00
_Y
350
_Y
250
350
-1 40
+1 00
-11
Net lncome
+Depreciation
,:
Cash Flow
210
150
+1
00
250
500
'l
310
398
present worth of positive and negative after-tax cash flow for an investment
equal to zero. This is another way of saying DCFROR is the rate of return
that makes after-tax NPV equal to zero. Discounting means to ,.present
worth" and the name "discounted cash flow rate of return,, comes from the
fact that classically, present worth or discounting equations most often
have been used to obtain the DCFROR. It already has been shown many
times earlier in this text that the same rate of return results from writing an
incomes (or negative and positive cash flow) at any poini in time, as long
as all cash flows are brought to the same point in time. It was mentioned
earlier in this chapter that other names commonly used for DCFROR are
Profitability Index (P.I.), Investor's RoR, True RoR, and Internal RoR or
IRR. Polls of industry presently indicate that DCFROR is the number one
economic evaluation decision method used by about two thirds of industrial companies that use a formal economic evaluation procedure to evaluate the economic potential of investments. In this regard it is relevant to
note that most major industrial companies use formal discounted cash flow
investment evaluation procedures of the type described, discussed, and
illustrared in this text.
Net present value (NPV) on an after-tax basis equals the present worth
of pcsitive and negative cash flow calcurated at the after-tax minimum rate
of return. NPV greater than zero indicates a satisfactory investment. proiect DCFRoR is compared to the after-tax minimum rate of return, .,r*,,, ,-o
determine if a particular project is satisfactory compared to other alternative uses that exist for the investment capital. For after-tax analysis using
any valid analysis technique, the minimum rate of return, ,,i*,,, must ie
expressed on an after-tax basis. comparing an after-tax DCFR)R
for a
ii
1i
;
I
t
1,
i
{I
400
it is imperative
rates
Cnapter 8: lncome Tax, Working Capital, and Discounted Cash Flow Analysis
convention.
conver,ticn.
402
Revenue
-Oper. Costs
-Depreciation
-Write-off
Taxable lncome
-Tax @ 4O/o
lncome
+Depreciation
Net
+Write-off
-Capital Costs -100.0
80.0 84.0
88.0
_34.0
92.0
Cumulative
96.0
44A.O
-30.0 -32.0
-36.0 -38.0
-10.0 -20.0 -20.0 -20.0 -20.0
36.0
_14.4
19.2 20.4
20.0 20.0
21.6
20.0
-10.0
-170.0
-90.0
-10.0
28.0
170.0
-11.2
-68.0
+ 41.6(P/F;,4) + 46.8(p/F;,5)
DCFROR = 27.45o/o
r?
I
.l
16.8
20.0
10.0
i:
102.0
90.0
10.0
_100.0
102.0
Chapter 8: lncome Tax, Workrng Capital, and Discounted Cash Flow Analysis
I
I
q
i
i
Note that cumulative depreciation over the 5 year project life plus
the write-off equals the $100 capital cost as with straighi line depre_
ciaiion. However, the timing is different and the taster deductions
(bigger deductions in early years) with MACRS depreciation retative
to straight line give faster tax benefits and better economics as
shown by the 29.0% DCFROR with MACFIs depreciation compared
lo 27 .45"/" with straight line depreciation.
Year012g4
80.0 84.0
Revenue
-Oper Costs
88.0
5 Cumulative
92.0 96.0 440.0
-Depreciation
*Write-off
-5.8
Thxable lncome
-Tax @ 40"/"
Net lncome
+Depreciation
+'vVrite-off
PWEq:0
i-
5.8
-100.0
Cash Flow
-5.8
41.7
40.1 (p/Fi,3)
102.0
404
Year
Revenue
-Oper Costs
-Research
-Loss
-100.0
Fonruard
lnc.
Taxable
-Tax @ 40"h
-100.0
-50.0
-0.8
-1s0.0
2.0 54.0
-100.0 -50.0
-50.0 .2
Forward 100.0 50.0
PW Eq:
Cumulative
51
-21
58.0
-23.2
-68.0
33.6 34.8
-48.0
56.0
.6 -22.4
32.4
i
i
20.0
150.0
102.0
+ 33.6(P/F;,4) + 34.8(P/F1,5)
i = DCFROR=32.65%
Chapter 8: lncome Tax, Working Capital, 6nd Drscounted Cash Fiow Analysis
Year
80.0
Revenue
-Oper Costs
84.0
-30.0 -32.0
-Research
-100.0
Cumulative
-68.0
1.02.0
'170.0
*Capital Costs
Cash
'i
'
Taxable lnc. -100.0 50.0 52.0 84.0 5e .0 58.0
-Tax @ 40% 40.00 -20.A -20.8 -21.6 -22.4 -23_2
Net lncome *60.0 90.0 g1.Z gZ.4 93.6 34.8
PW Eq:
0 = -60.0 + 30.0(P/F;,1)
102.0
+ 31 .2(plFi,2) + Sz.ap/F,,g)
+ 33.6(P/F;,4) + 34.8(p/Fi,5)
= DCFROR=44.16%
The reader should observe from these anaiysis results that the
faster an investor realizes tax deductions and the tax benefits from
the tax deductions, the better the economics of projects become.
Expensing the $100,000 cost against other income gives a 60"/o
increase in the DCFROR that is obtained by straight line depreciation of the cost. lf you have to carry negative taxable income forward
to make the project economics "stand alone', as in part ,,C,,'the project economics do not look as good as when other income is
assumed to exist against which to use deductions in the year
incurred, as in part "D."
part "D" as
Finally, as an alternative to treating the research cost in
of 1'0 in
rate
a
wlth
I tax ex[ense_ item, consider it to be depreciablepraciice,
so
in induStry
rcat A. fnis iS an approach'sometimes'used
:he reader should be'aware of the equivalence of either apprgach aS
"D" illustrate'
:he following year 0 cash flow calculations for part
An Alternative to
"D"
year
an
Research as
ExPensed Cost
Revenue
-Oper Costs
-Besearch
-Research as DePreciation
-100.0
Taxable lncome
-Tax @40"h
-100.0
year 0
Research as a
DePreciable Cost
-100.0
-100.0
40.0
40.0
Net lncome
+Depreciation
-Capital Costs
-60.0
-60.0
Cash Flow
-60.0
100.0
-100.0
-60.0
Example 8-6 involved a single investment cost that was either depreciated
invenor expenied for tax deduction purposes. Most businesses also require
,ory .ortr, commonly called working capital' which are not depreciable as
discussed in the following section.
Chapter 8: lncome Tax, Working Capital, and Discounted Cash Ftow Analysis
407
and w'hy it is not deductible for tax pulposes in the yezr it is incurred,
is to con_
sider the determination of the "cost of Goods sold" as it is handled
on corpor.rte or individual business tax returns. Table 8-3 illilstrards the
sreps necessarv to calculate the annual cost ofgoocls solii for a business operated
either by
iii; iilCii idual, partiership or corporation. in this cost o1'go64siold calculation,
i.riue oi inventories rrt the;,ear end is working capital and is not rax deductible.
408
items purchased during a tax year are the cost basis for inventory assets tied
up in working capital.
409
$21
$zt
$21
Ci 2
$zt
$10
$15
$tz
1,000,000
1,000,000
1,200,000
nventory lnformation
Year
Units Produced
Units Sold
Change in lnventory
Cumulative lnventory
500,000
1,000,000
800,000
5O0,0OO
500,000
200,000
700,000
s00,000
-700,000
700,000
Solution:
In comparing the FlFo, LlFo, and average inventory accounting
economic results for the analysis, note that LlFo givel the largest
cost of goods sold operating cost deductions and the smallest working capital costs in early project years relative to FlFo and average
inventory accounting results. Therefore, the best economic results
occur with LlFo. with escalating production costs from year to year,
LlFo always gives faster tax deductions relative to FlFo and aveiage
inventory accounting, which is why virtually all large U.s. companies
use LlFo inventory accounting for all major raw miterial and product
inventory items. For this analysis, and in general for all analysis situations, average inventory accounting givel project results that are in
between FIFO and LIFO results.
410
A)
23
Revenue
- Cost of Goods Sold"
- Depreciation
- Deprec. Write-off
0
0
0
Taxable lncome
0
0
-fax
@ 4Oo/o
6,471,000
-2,599,400
4,951,000
-1,990,400
79,000
-31,200
Net lncome
0
3,892,600 2,970,600 46,900
+ Depreciation
0
1,429,000 2,449,000 6,122,000
- Capital Equipment -10,000,000
- Working Capital*. -5,000,000 -4,1oO,OOO -1,4oO,OOO 1o,50o,OOO.
Cash Flow
DCFROR = 15.150/"
-15,000,000
,21
,600 4,019,600
16,668,900
*Cost of Goods
Sold = COGS
COGS = Value of Units From tnventory + production
Yr 1 COGS: (500,000 * $10) + (300,000 * $13) = g8,900,000
Yr 2 COGS: (700,000 x $13) + (300,000 * $1S) = g18,600,000
Yr 3 COGS: (700,000 x $15) + (500,000 x $17) = g19,000,000
Note: The year 3 COGS represents the gg,500,000 cost of product
produced in year 3, along with the $10,500,000 write-off value of
inventories drawn down to meet product sales in that year.
**Working Capital
= Cost of Units produced - COGS
Yr 0 Work Cap: 500,000 * $10 - 0 = $5,000,000
Yr 1 Work Cap: 1 ,000,000 * $13 - $8,900,000 = $4,100,000
Yr 2 Work Cap: 1,000,000 + 915 - 913,600,000 = $1,400,000
Yr 3 Work Cap: 500,000 * $17 - $19,000,000 = (g10,500,000).
'Yr 3 Working Capital is a credit for reducing inventory.
-tl
j
,!
1
n
il
:i
Cha,:te!'B: Income Tax, Working Capitai. and Dlscounted Cash Flow Analysis
41'l
Revenue
- Cost of Goods Sold.
- Depreciation
- Deprec. Write-off
Taxable lncome
0
0
-Tax @ 40"/"
'r
4,97't,000 3,551,000
Net lncome
0 2,992,600
+ Depreciation
0 1,429,000
- Capital Equipment -10,000,000
- V/orking Capital." -S,000,000 -2,600,000
Cash Flow
DCFROR
2,130,600 1 ,786,800
2,449,000 6,'122,000
15.7A%
2,978,000
7,600,000.
15,508,800
*Cost of Goods
Sold = COGS
coGS = Value of Last units produced + Necessary lnventory
Yr 1 COGS: (800,000 * $13) = 910,400,000
Yr 2 COGS: (1,000,000 * $15) = $1S,OO0,0OO
Yr 3 COGS: (500,000 * $17) + (200,000 * $13)
+ (500,000 yr 0 production) x g1O = $16,100,000
Note: The year 3 COGS represents the gg,500,000 cost of product
produced in year 3, along with the 97,600,000 write-off value of
inventories drawn down to meet product sales in that year.
** Working
Capital = Cost of lnventory produced - COGS
Yr 0 Work Cap: 500,000 * $10 - $O = $5,000,000
Yr 1 Work Cap: 1,000,000 * giS - 910,400,000 = 92,600,000
Yr 2 Work Cap: 1,000,000 * 915 - $15,000,000 $0
=
Yr 3 Work Cap: 500,000 * $17 - $t 6,1 o0,0oo = (g7,600,000).
"Yr 3 Working Capital is a credit for reducing inventory.
412
Revenue
- Cost of Goods Sold*
- Depreciation
- Deprec. Write-off
0
0
0
Taxable lncome
0
0
5,77'.1,O00 4,796,294
-2,309,400 -1,914,519
-Tax
@ 4O%
0
0
Net lncome
+ Depreciation
- Capital Equipment -10,000,000
- Working Capital** -5,000,000
942,706
.-377,O92
Flow
-15,000,000 1,4g1,600 4,OgS,4g2 16,g22,91g
DCFROR = 15.35%
NPV @ 12o/o = g1,207,03g
Cash
*Cost of Goods
Sold - COGS
coGS - Average Varue of Units produced and sotd Each yr
Yr 0 COGS: (500,000 produced, none sold) g0
=
Yr 1 COGS: (($tO * 500,000 + $13 * 1,000,000)/1,500,000)
* 800,000 = $9,600,000
Yr 2 COGS: (($tZ * 700,000 + 915 * .1,000,000)/1,700,000)
* 1,000,000 = $1 9,764,706
Yr 3 COGS: ($13.70 x 700,000 + $17 * 500,000) g1B,.t gS,Zg4
=
Note: The year 3 COGS represents the $g,500,000 cost of product
produced in year 3, along with the $9,635,294 write_off value
of
inventories drawn down to meet product sales in that year.
** Working
Capital = Cost of Goods produced - COGS
Yr 0 Work Cap: $10 x 500,000 - $O = $5,000,000
Yr 1 Work Cap: g'13 ,r 1,000,000 - 99,600,000 $3,400,000
=
Yr 2 Work Cap: g1S x 1,000,000 g19,764,206
= $1,23i,2g4
Yr 3 Work Cap: 917 * 500,000 $t g,1g1,Zg4 $9,635,294"
=
'Yr 3 Working Capital is a credit for reducing inventory.
ll
chapter 8: lncome Tax, working capitar, and Discounted cash Frow Anarysis
413
'
Year
Revenue
300
-Operating Costs
-Depreciation
-Write-off
Taxable lncome
-Tax @ 4A"h
Net lncome
r-Depreciation
+Write-off
-Capital Costs
Cash Flow
1
-200
-oo
:
80
60
-32
-24
48
_;
Z_s
300
-2AO
7-9
10
300
300
400
-2A0
-200
-200
100
-60
140
-40
-56
-:o
80
-JZ
48
.:
60
84
+60
+144
capital return.
working capital invesiment tax deduction write-off.
NPV Eq: 0 = -260 + 68(piF;,1) + 76(p/A;
,4)(ptFi,1) + 68(p/F;,6)
+ 60(P/A;,3)(p/F;,6) + 1 44(p /Fij g)
DCFROR = 25.24o/o, NPV @ 12/o +$160.6
=
.. original
/L
**
414
Year
Revenue
300
-Operating Costs
-Depreciation
-Write-off
-200
-!
Net lncome
+Depreciation
+Write-off
-Capital Costs
Cash
Flow
7-19
2-5
300
-200
i'
300
-200
-!
80 60
-32 -24
Taxable lncome
-Tax @ 40"/"
48
36
:,
80
-32
48
.:
20
300 400.
-200 -200
-60 "*
100
-40
140
-56
60
84
-260
-260
+144
NPV Eq: 0
+ 68(P/F;,1) + 76(P/A;
,4)(PlFi,1) + 68(P/F;,6)
+ 60(P/A;, 1 3XP/F;,0) + 1 44(P /F i,2g)
= -260
Although beforetax profit literally doubles for the 20 year life project
as compared to the 10 year life project, DCFROR only increases 1.5%
(trom 25.2/" lo 26.7"h, a 6% change). The change in NPV due to doubling the project li{e, however, is much more significant. The 20 year life
NPV of +$251.5 is $90.4 greater than the 10 year life prolect NPV of
$160,6 (a 56% increase). Discount rate magnitude is the reason NPV
results, in this case and in general, are more sensitive than DCFROR
results to changes in cash flow beyond 10 years in the future. 'l-he NPV
discount rate of 12/"is smaller than the DCFROR results of 25.2/" and
26.7"/". As a result of the mathematical definition of the single payment
present worth factor, (1/(1+i)n), larger values of "i" cause the present
worth factors to be much smaller than for smaller discount rates when
the evaluation period, n, is 10 or greater. ln this analysis, since the 12%
NPV discount rate is much smaller than the DCFROR rates, this
causes the years 11 through 20 cash flows to have a much greater
impact on the NPV result than on DCFROR result.
415
Cash
Flow -260 O
3-6 7 8-10 11
+69 +76 +6g +60 +144
416
eign tax cash flow usually is the worst case analysis that the
investor should
use to evaluate the ecolomic potential of the foreign project.
However, differ_
ences in tax deduction methods (for example, depletion
usually is not applica_
ble in foreign countries) and asset tax lives, as well as tax iate
diffeiences,
affect foreign project evaluations. Investors must be careful
to analyzeproject
economics from both a foreign tax and domestic tax viewpoint
to determine
the worst case project cash flow stream that is relevant ftr
evaluation pur_
poses. In doing the u.S. tax analysis of a foreign
U.S. project, ailowable tax
deductions generally are different (usually smaller; ttu, ro,
a oomestic u.s.
project. For example, u.S. mine development or intangible
drilling costs can
be 70vo expensed, 30vo amortized over five years by specified
u.s. domestic
producers, but these costs must be deducted straightlin"
or"r 10 years for
u.s. tax on foreign projects. Allowed depreciation on foreign projects
seems
analogous to allowed domestic U.s. depreciation for alternative
minimum
tax. contact your international tax department for specific project
tax details.
tte
of a
"hung"
foreign project in comparison to an equivarent domesiic
"conomics
U.S.
project. The
following example illustrates how exchange rate projections
are used in an
economic analysis involving two currencies, and the sensitivity
of DCFRoR
and NPV results to exchange rate projection variations.
EXAMPLE 8-Ba Exchange Rate variation for DcFRoR
and Npv
,.
Sensitivity
To illustrate how exchange rate projections rerate to an
international. project anarysis, consider the Exampre g-g, case
A project to
be a u.s- project so arr revenues, sarvage varue, capitar
costs, operating costs, tax deductions and cash flows are in u.s.
oottars. How_
ever, assume the revenues have been generated by seiling
1,ooo
grodugJ units per year in Austraria at a fr-xed contraci price of
9400
Australian per unit for a base case exchange rate of
per
U.S.
$b.ZS
$1.00 Australian. This gives $400,000 Australian revenue per year
1)
dollar.
2)
417
Revenue
- Operating Costs
- Depreciation
* Write-off
Taxable lncome
* Tax @ 40"/o
l.let lncome
+ Depreciation
+ Write-off
- Capital Costs
260
_200
0
10
*360
-2AO
0
*"-50
40
2A
40
60
1'30
-16
-8
-16
-24
-+U
02412243660
02A402000
0000060
-260
Cash Flow
-260 44 52 44
120
* Revenue
includes $100 U.S. salvage and working capital return.
*"
original working capitar investmenl tax deduction wiite-ott.
36
44(p lF i,6)
418
2 shows,
better.
10
340
340
-200
-20
-200
"440
-200
2-5
Year
340 340
-200 -200
-20 40
Revenue
- Operating Costs
- Depreciation
- Write-off
Taxable lncome
- Tax @ 40%
Net lncome
+ Depreciation
+ Write-off
- Capital Costs
Flow
0
0
120
-48
100
40
0
72 60
020402000
0000060
140
-56
72 84
**-60
120
180
-48
-72
108
-260
-260 92 100
92
84
Cash
168
* Revenue includes
$100 U.S, salvage and working capital return.
.. Original working capital
investment tax deduction write-off.
NPV Eq: 0
Chapter 8: lncome Tax, Working Capital, and Discounteo Cash Flow Analysis
419
depietion deductions also are unique to minilg and petroleum pro-iects. All nining ltroducers and independent petrolettm producers get to take the greater of
allctvt,ed percentage depletiott and cost depletion, while integrated petroleutn
producers are only allowed to take cost depletion on oil and gas productiort.
There are some unique severance and excise tax considerations related to mineral and petroleum projects. Most non-mineral, petroleum and mining projects
alike involve depreciable costs, so there is nothing unique to mining and
petroleum project evaluatjirns in this regard. A typical mining/petroleum project
discountcd cash flow analysis is illustrated in the foilowing example.
An investor is considering acquiring and developing a mineral property believed to contain 500,000 units of mineral reserves (mineral
units could be barrels of oil, tons of coal, ounces of gold, etc.). The
mineral rights acquisition cost for the property would be $g00,000 at
420
Chapter B: lncome Tax, Working Capital, and Discounted Cash Ftow Analysis
1-rt
3,000 3,300 3,630 3,993 4,392
Revenue
I
d
*
t
*
-Royaiiies
Net Revenue
-Oper Costs
-Deveiopment
-Depreciation
2,550
ir
Net lncome
rDepreciation
+Depletion
-rWork Cap Ret.
-143
704 74A
-g}z"** 421
180 .129
384 -328
-816
-245
1,407 1,490
-1,2A0 1,025
3,086 3,394
2,805
-659
3,733
-1 ,260 -1 ,360
2,009 2.061
1,005 1,030
-463
-560
*509
32
1,059
1,281 1,500
-339
-410
871
175
463
-480
1,50i
-480
1,020
1,020
312
560
300
2,199
697
143
382
720
245
421
125
509
The capital cost is $300 working capital, gg00 mineral rights acquisition cost and 91,000 depreciable equipment.
*" The write-off
of remaining book values is combined with year 5
depreciation.
*** The allowable
depletion deduction has a minus (-) sign in front of
it since it is the largest allowable deduction.
422
Depreciation Calculations
Period ACRS Rate
Cost
Depreciation
142.9
244.9
124.9
124.9
Cost Depletion
(100/s00xe00) = 16s
(1 00/400X900-382)
= 129
(100/300x518-421) = 32
gg.3
229.1
DCFROR Calcutation
0 = -3,0 1 6 + 1,222(P/F;,
) + 1,3g6(p/F;, 2) + 1,50g(piFi,3)
+ 1,654(P/F;,4) + 2,193(plFi,5)
1
i=DCFROR=39.15%
NPV Calculation tor i* 20yo
=
NPV = 1,222(PlF
20,1 ) + 1,386(p/F29,3)
+$.1
,517
PVR Calculation
1
Chapter 8: lncome Tax, Working Capital, and Discounled Cash Flow Analysis
Fevenue
Revenue
-Oper Costs
Net
2,SS0
-Development -1,200
2,805 3,C96
3,334 3,733
*143
-245
*175
1,407
704
1,490
740
-382
180
4,20A
-175
reciation
Before Deplt
*50% Limit
-Percent Deplt
-Cost Depli
-Loss Forward
*1,200
-1,200 -175
00
-Tax @ 32/"
Net lncome -1,200
-175
+Depreciation
143
+Depletion
382
Taxable
+Loss forward
-125
-312
1,744
872
2,009
1,005
2,061
1,030
42',|
-463
129
-509
-560
32
1,29"1
1,500
1,501
-410
-480
-480
884
-283
1,200
601
245
421
175 125
463 509
312
560
175
4,392
-Royaities
300
$300 working capital, gg00 mineral rights acquisition cost, and $1,000 depreciable equipment.
** The
write-off of remaining book value is combined with year 5
depreciation.
*** The allowable
depletion deduction has a minus (-) sign in front of
it since it is the largest allowable deduction.
PW Equation
0 = -3,400 + 1,550(P/Fi,1)
+ 1,654(P/Fi,4)
* 1,442(PlFi,2) + 1,509(P/F;,3)
* 2,193(P/F;,5)
424
Year
Revenue
-Royalties
-Development -840
-Amortization -72
Taxable
-Tax @ 38%
Sj
3,ggg-- 4,gg2_.
-Depreciation
Deplt
4--t
Net Revenue
-Oper Costs
Before
-50% Limit
-Percent Deplt
-Cost Deplt
g
1
Z
3,000 9,900 3,690
3,733
-143
-72
-245
-72
-175
-72
-125
***"
-312
-72
1,937
704
1,672
836
-382
421
180
-463
129
32
-509
-560
-912
953
987
1,209
1,429
1,501
347
-362
-375
-460
750
-543
-570
-912
1,335
668
1,409
969
2,061
1,030
Net lncome
591
612
-565
886 930
+Depreciation
143
245 175
125 312
+Depletion
382
421 463
509 560
+Amortization
72
72
72 72
72
-Work Cap Ret.
300
-Capital Costs -2,560*
Cash
1,199 .l ,3SO 1 ,460 1,5g2 2,10g
-3,053
* The capital cost
is $300 working capital, $g00 mineral rights acquisition cost, $1,000 depreciable equipment, and 307o of t-ne g1,200
development cost.
** The
$72 amortization deduction in years 0 through 4 is
( 1 /5X0. 3X$ 1,200 Minerat Devetopment).
*** The
allowable depletion deduction has a minus (-) sign in front of
it since it is the largest allowable deduction.
**** The
write-off of remaining book value
combined with year S
depreciation.
Flow
DCFROR Calculation
0 = -3,053 + 1,188(P/Fi,1) * 1,350(p/Fi,
2) + 1,460(p/F;,3)
+ 1,592(PlFi,4) * 2,1 03(piF1,5)
i=DCFROR=36.79%
Y'
i
*
I
*
Chapter 8: lncome Tax, Working Capital, and Discounted Cash Flow Analvsis
f;
I
Il
i 3,053=0.4360
Revenue
3,000
3,300
3,630
3,993
4,392
-Rovalties
-450
-495
-545
-599
=659
Net Revenue
-Oper Costs
-lniangible
-Depreciation
-Amortizat!on
-Cost Deplt
Taxable
-Tax @ 38%
i\'let lncome
+Depreciation
+Depletion
+Amortization
+Work Cap Ret.
-14s
-912
347
-565
72
-125
-245
-72
-175
-72
80
-1 80
-1 80
-180
-180
1,155
1,228
1,757
1,981
-439
-467
1.492
-567
-668
-715
716
143
761
925
1,090
1,166
245
180
72
180
175
180
72
-zz**_1-lz
72
-312
-72
125
180
312
180
72
300
$300 working capital, $900 mineral rights acquisition cost, $1,000 tangible depreciable equipment and 30% of the
$1,200 intangible driiling cost (lDC).
426
DCFROR Calculation
0 = -3,053 + tri1 1 1 (F/F;,1) + 1,2S9(p/Fi,Z).* 1,352(p/F;,3)
+ 1,467(PlF;,4) + 1,958(p/F;,5)
= DCFROR=33.12/"
ZC;/o
1,023/3,053=0.3350
levenue
{et
Revenue
-599
4,392
-659
g,3g4
3,733
3,993
,166 -r
'let income
-Work Cap Ret.
-Capital Costs
)ash
,eoo -1,360
-3,400"
1,225(plFi,2) + 1,g19(p/F;,3)
* 2,670(p/Fi,5)
= DCFROR=45.32/"
427
ChapterS:lncomeTax,WorkinECapital,andDiscountedCashFlowAnalysis
2}o/o
Z.1iiglg,400=O.67Zs
It is irnportant to proiect inflows and outflows of money from either
revenues, costs or iax savings and tax costs to fit the investor Situation and physical proiect timing as closely as possible. Only if this is
done will evaluation results be valid for economic decision making'
PROBLEIVTS
potential of
project
with time zero cost of $1,000,000 for research, a $400,000 cost for
land, $1.400,000 for a bullding, $300.000 inventory cost for raw materials and spare parts and s2,000,000 for equipment. For income taxes,
q.ill be
rhe research cost will be expensed at time zero; the equipment
depreciate,3 over five years using the MACRS rates from Table 7-3
(star1 depreciation in year 1). The building u'ill be depreciated stiaight
line ovei 39 years with a full year deduction beginning in year one. The
land, inventory costs, equipment and building book value will all be
written off against the escalated dollar sale value of $4,000,000 at the
endofy"u.3'Theprojectisestimatedtogenerateendofyearlrevenue of $3,000,000 and operating costs of $1,000,000. Both will escalate 8.07c per year in years 2 and 3. The effective corporate ordinary
income tax rate is 40.07c with any gain on the year 3 sale treated as
ordinaq.\. income. Determine the DCFROR, NPV and PVR for an aftertrix escalated dollar minimum rate of return of 15'A7a
A)
Assume a "stand alone" financial situation and carry losses forward to be used against project income'
B)
428
Cost=$50,Q09,.
Res & Experiment
Cost = $100,000
_
^
0
Working Capital
Return=.$20,000
Sales=$500,000. . . . . Sales=$500,000
rt.vv_vTvvrvvv
A)
B)
c)
D)
1)
2)
Chapter B: lncome Tax, Working Capilal, and Discounied Cash Flow Analysis
8-3
429
B)
Other taxable income does erist so realize tax benefits from negative taxable income in the year incurred.
8-1. Annual
Cash
cash
Flow
Year
As the year 1 through 4 positive cash flows are realized it is anticipated that they will be invested in treasury bonds paying l2Vc annual
interest and maturing at year 4. Calculate the DCFROR and the
Grora'th DCFROR on the investment, assumiug a 40c/o income tax rate
rrq
430
8-5 A manufacturing
l-7
Chapter 8: lncome Tax, Working Capital, and Discounted Cash Flow Analysis
431
BPD in years 3 through 6. Assume oil will sell for $22 per barrel
(before royaities of L4%o of sales) in the first producing year, with oil
price escalating by 87o annually thereafter. Assume 350 operating
days per year. operating costs are estimated to be $175,000 in the firsi
producing year and escalating 107c annuaiiy until production is suspended at the beginning of year 7. XyZ corp. has an effective tax rare
of 38%o, The company has other oil income against which to expense
pre-tax losses, however all oil production by the company is less than
1000 BPD now and in the foreseeable future. The welicompletion and
producing equipment costs will be depreciated by modified ACRS
depreciation for a7 year depreciation life starting in evaluationyear Z
with the half-year convention. use DCFRoR and Npv (for i =L|vo) to
evaluate this investment for the 6 year project life if the company is an
,l
independent and:
fl
A)
,*
E
B)
il
$
r
C)
D)
8-8
8-9
62 53 35 24
Production, (gal)
Research
750
Equipment
Patent
Rights
100
Operating Costs
Price, ($/gal)
17
250
670
t75
26.0
256
28.7
1)
B)
.t
433
Chapter 8: lncorne Tax, Working Capital, and Discounted Cash Flow Analysis
Production, (Bbls)
Intangibles, (IDC's)
Tangible (Completion)
Mineral Rights. Acq. 100
Operating Costs
750
Price, ($/Bbl)
62 53 35
24
t7
250
670
256
28.7
l)
B)
2)
3)
434
4)
s) Analyze the break-even crude oil price per barrel that received
uniformly from years 1 through 5, wourd make this project yield a
157o DCFROR for the investor and tax scenario in part ta.
6)
Production in thousands.
Year
Production in Tons
Mineral Development
Mining Equipment
Mineral Rights. Acq. 100
Operating Costs
750
62
53
35
24
t7
250
670
256
28.7
40.AVo
rates,
1)
Chairter 8: lncome Tax, Working Capitai, and Discounted Cash Flow Analvsis
A)
B)
435
2)
Risk adjust the Part 1A analysis assuming 407o probability of success with the year 0 costs and 60% prci-rability of failure with failure resulting in a year I net abandonnent cost of $70,000 to he
expensed in that year against other income. If failure occurs, a
write-off of remaining book values on mineral rights acquisition
and mine development costs will be taken at year 1.
3)
and,Zfor an
ducer.
4)
Analyze the break-even net smelter return per ton of ore that,
re-:eived uniformly from years I through 5, would make this project
yield a 15olo DCFROR for the investor and rax scenario in Part 1A.
5)
CHAPTER 9''
9.1 Introduction
DCFROR is used more widely as an after-tax investment economic
decision
method than all other economic decision methods. Npv is
the second most
used economic decision method and ratios ar.e the third
most used evaluation technique. These discounted cash flow investment analysis
techniques
are the best approaches known today for evaluating the
economic potential
of alternative investments. It is important to remember that all of the discounted cash flow techniques are systematic, quantitative
approaches to
i
i
:
'i
43Q
*
*
*t
t
437
\'ou Lrr)alvze a project in escaiated dollars you must compare it with results of
orher projects analyzed in escalated dollars, As discussed in chapter 11, if
\,(iu le\ei^age a proiect investmeni \.vith bDrroued money,
1,ou should com_
pare it to other projects analvzed x,ith simiiar borro-..ved mcne)r ler.ei:age.
Srirriarly, ri'hen considerins an investor's mininrum raie of return, it is
ir:rpt.rr".int to recognize that i{ the financial cost of capital approach is to be
uLiiizc'J. the cost of Cebt ard the risk free bond rate of retum lrsed in the capital
rs:r:t 111eigl rnust be e.rpressed on an aller-tax lrasis. This requires recognition
thill tile cost ot iinancing is generally deductible (except for construction loans
- :'ce Chapter 1i fbr more details). Further, interest received from an investmenr in bonds would be treated as ordinary income upon rvhich taxes must be
paio. These adjustments are easily achieved by multiplving each parameter
tinres the quantity (1{ax rate). The resulting product(s) represent the after-tax
cost ,.>f borrowed mone)' interest and the after-tax rate of return from a bond
occurred in most industries around rhe world in the 1960's and 1970,s. prior
to that time, techniques of analizsis such as payback period, which is
described in the next section, and several different average and/or accounting rate o1'retttrn calculations which are d*fined and illustrated in Section
9.1()
oi this
9.2
cash
438
If an investor
is considering a
t:
r
$
meet short-term cash flow needs, even though these projects have
much poorer
economic potential than other potential investments with longer payback
periods.
$
1:
Year
ATCF
-'100
-200
150
200
439
250
Solution:
This project has a DCFROR of 32.85% and an NPV @ 12.0oi" ot
$142.24, both of which indicate a.cceptable economics. For Payback,
assume the time zero cdsh flow is a discreie sum at thai poirrt and
thai tne subsequent cash flows in periods 1 through 4 flow continuousiy during each corresponding year.
Payback From the Start of the Project, (Time Zero):
______>_r
2i
Year
ATCF
CUM ATCF
lzoo
50
250
300
0
1
2
13
150 200
-100 -200
-100 -300 -150 50
250
300
1 Year + (150
the stariing reference point does. So looking back from the payback point to the start of production is 1.75 years.
440
Year -.:
0
ATCF
-1 00
DATCF
-100
CUM DATCF -100
3
200
142
4
250
-17
142
159
200
150
100
OrscountedPayDa"k,3.,
years
50
s
o
-50
t_
-1 50
-200
-250
-300
Years
01
DATCF -100
CUM DATCF -1OO
_179
_279
150
200
142
250
-17
142
120
-1 59
159
441
$28s.6
4 years
$46.2
$46.2
$46.2
$46.2
4 years
Soiution:
Assurning revenue is realized uniformly over year 4:
Project "A", Undiscounted payback 3 + (100/2g5.6)
=
= 3.35 years
lf the project "A" revenue is assumed to be a lump sum revenue
such as from the sale of real estate or common stock, then
the project "A", Undiscounted payback is 4 years.
Project "B", Undiscounted payback 2 + (1 oa-g2.4)/46.2
=
= 2.16 years
undiscounied Payback indicates select project ,,8,, with the
smaller
pa;,'back.
A)orzs4year
at
- - -
12yo
$2g5.6(p/F1e,4)=$1gt.5
,u,
012
442
NPVA = 285.6(P/Ft2,4)
00 = +$40.3
PVR4=81.5/100=+0.815
PVRB=40.3/100=+0.403
Since both ratios relate to the same investment dollars, select "A",
+$239.4
4 years
n9.af lFi,a)
= 12/"
).3
443
l'i ecoulrmic evaluation work we verY frequently find otrrselves con'rollr'(i u'ith analysis of determining the most economic way to provide a
.,rr'\ti-e. -fitis is the most conl)ton type of evaluation probleur of all and in
- rr il,l:er -] rve ciiscusscd the fivc basic economic analysi. approaches to ana.2,: iiris rlpe of problem. The |r'e basic approaches are (11 comp:trison of
r. ..1.tnt ui.rth CrlStS, (2) corlperison of annuAi worth C0SIS, (3) Coinparison
.i'iuiiire.,r.orth cttsts, (:1) increniental ROR or Net Value Analysis or (5)
:,r'.';rl,-ei'e n analysis such as service life break-el'en analysis' Of these flve
t-rL-ill()(ls increntental ROR arid Net Value analysis are very popular because
rf rlrc large nunlber of companies and individuals that use ROR and Net
r'aluc analS'sis irs the primary decision making criterion for all types of proect analyses. Incremental analysis of alternatives that provide a service
ii,,r.21,q generales ilcremental costs :tnd savings, and dtlllars saved are just
' r.:,jr' :.tls elrttcd !
For t$ter-tttx DCFRC)R, Net Value, or Rario anal-r*sis of alternatives
'ttvrtlving srrllrzgs
1'ou ntrtst CotNert savirtgs to after-ta.r cash flovt e.\QctLv
'Ite sone tis irtcrenrcntal itrcome rnust be converted to cash flow. If an increne:rfal int'esturent genelates sar inss b1' redLrcing operaiing costs bel0\' a
:orrler lcvel. thc. lower operating costs will result in lou'er tirx deductiotls
'br operatiug costs which means you have morc taxable illcome in the sarrre
titr{-}unI as il'the savings wcre incremental revenue.
'fhe follourng example illustrates DCFROR and NPV analysis of
an
444
ing prices. The effective income tax rate is 40"/" and the minimum
DCFROR is 12/". Use DCFROR and Np.v anqlysis.!g delgryine if it
is economical to buy the n.* rorfressor. Assume other income
exists against which to use deductions in any year.
otd
t
0
tew C=
F($3.00/|\4CF)
1....
......10
$.oo/McF)
New C=$420
S = $240
S = $240
-ord
Year
1-6
Revenue
-Depreciation
Taxable lnc.
-Tax
@ 4O"h
Net lncome
240 240
-30 -60 -30
-30 180 210
12 -72 -84
-96
144
+Depreciation 30
-Capital Costs -420
Cash Flow
8-10
60
240
24A
30
144
445
i = DCFROR=
39.2/o>i*
=12."/o,
Npv
4.111
0.4523
i lzx = -408 + 168(piAi2,6) + 156(prF12,7)
2.402
0.4523
+ 1 44(Pl A12,9(Plr
satisfactory
The DCFBOFI of 39.2"/o, which is more than three times the minimum DCFROR of 127", indicates very satisfactory economics for the
nev'/ compressor, consistent with positive NPV of $510,000 that is
greater than tne cosi of $420,000 that generated the NPV. Whenever
NPV is pasitive and similar in magnitude to the cost that generated it,
project economics are very good and typically relate to a proiect with
a DCFROR three or four times the minimum DCFROR.
9.'1 Sunk Costs and Opportunity Costs in Evaluations
Srtttk costs are cost., that have already been incurred in the past and that
n()llting v'e do now or in the.t'uture cen affect. Economic analysis studies for
invesrrnenr decision making purposes deal with project costs and revenues
artd iax ettrcts yet to be incurred now or in the future. Sunk costs are not
r.'levont ro the anal ,-sis of either income or sertice producing investment
alternativ,es except for remaining sale value and tax effects, yvhich are
opporturtitl' cost considerations discussed in the next paragraph. Past commitments to expend money as well as past expenditures are sunk revenues
and costs. Revenues realized in the past from a projerct are sunk revenues
the same as past costs are sunk costs. Classic examples of sunk costs
include the costs of equiprnent acquircd several years ago and now being
considered for replacement, the costs for research or exploration work
incurred in earlier years, an<i the cost of common stock or land several years
ago tbr a personal investment. In all of these situations the cost is in the past
and, except for remainin-e sale value and tax effects, is not relevant to our
analysis of whether to develop, keep or replace the asset or investment.
Opportunity cost is hidden or implied cost that is incurred when a person
or orgardzation forgoes the opportunity to realize positive cash flow from
446
fi
income, giving total cash flow from selling of $11.60 per share (gg sale
value plus $3.60 tax savings). An investor who forgoes selling for $g per
share is actually incurring an opportunity cost of $11.60 per sharc to keep
the stock. This rationale relates to common stock sales that stock brokers
often refer to as "tax selling."
Finally, the minimum rate of return (or opportunity cost of capital or hurdle
rate) is the classic example of the most widely used opportunity cost in economic analysis. As discussed in several places earlier in the text, the minirnum
rate of return is not the cost of borrowed funds, (an investor may not even be
using borrowed funds), but minimum rate of return represents other opportunities thought to exist for the investment of capital both now and in the future
over the life of a project. An investor incurs an opportunity cost equal to the
t
&
.i
447
Jcrrilp
The time diagram shows costs and revenues for a 6 year project
life with research costs in years -1 and 0 (year 0 represents ihe start
cf production with negative numbering of pre-production years). To
sirnpiify the cash flow analysis, consider the project to be nonmineral or petroleum, so depletion is not applicable. Assume the
year 0 equipment cost is placed into service at year 0 with straight
!ine, 5 year life depreciation starting at year 0 with the half-year convention. Escaiation of year 1 through 5 sales and operating costs is
projected to be a washout. Project salvage value is zero. Other taxabie income and tax obligations are assumed to exist against which
to use tax deductions in any year. The effective tax rate is 4O%. All
values are in thousands of dollars.
Research or
or
Exploration
Exploration Cost = 100
Cost = 150 Eq.Cost = 200
Research
Annual Sales =
--1
250
250
L=0
li
448
Year
1-4
-1
Revenue
-Cper. Costs
250
-90
-40
-90
120
140
250
-150
-Depreciation
-100
Taxable lncome
-Tax @ 40"/o
-1 50
60
-120
48
48
-56
Net lncome
+Depreciation
-Capital Costs
-90
-72
72
40
84
20
-Development
-20
20
-20
-200
-252
Cash Flow
112
PW Eq @ Yr -1:
0 = -90
- 252(p/Fi1)
i = DCFROR
= 16.7"k
+
>
11
2(P I Ai,$(P/F;,
) + 1 04(P/F;,6)
= 15"/", so satisfactory
Case B) Year
449
-1 Cost ls Sunk
The year -1 costs and tax effects are sunk and not relevant to the
analysis. No opportunity cost exists from not selling the property
because no year 0 sale value exists. Year 0 thrcugh 5 cash flows are
tne sairs as for part "A".
0145
-1
V,aar
-252 112
-90(Sunk) 0 0
0
-252 112
104
0
104
PWEq@Yr0:
A
-101-45
Year
Develop Cash
Sell Cash
Develop -
Florr
Sell
-372 112
104
0
104
PWEq@Yr0:
0=
i = DCFROR
450
Case D) Year -1 Cost is Sunk but Tax Effects are not Sunk.
The time zero sale cash flow is the $200 sale value minus the tax
on the sale taxable income of $200 - $150 land book value which
yields tax of $SO(0.4) = $20. This gives after-tax sale cash flow of
$200 - $20 tax = $180. Although the land cost of $150 is sunk, the
remaining sale.value and tax effects are not sunk and give sale
value cash flow of $180 instead of the 9120 cash flow in the,,C',
analysis when the year -1 cost and all tax effects were sunk.
lf the project is developed instead of being sold, the land book
value of $150 will be written off at the end of year five against other
income, saving $150(0.4 tax rate) = $60 in tax at year five. This
makes the year 5 develop cash flow 9104 plus $60, or $t O+.
Year
1-4
-1
+180 O 0
492 +112 +164
PW Eq @ Time Zero:
O
i=
The different tax situation with regard to the year -1 sunk cost has
changed the economics from break-even in "C" to an advantage for
selling in Case D.
451
452
on
development at time 0 to geneiate revenues for a 5 year period and
zero salvage value, what uniform and equal annual net revenues
after operating costs for years 1 through 5 are required to give:
0.4264
Net Revenue per year = $1s0,000(A/pg2,5) g60,960
=
convert all escalated dollar break-even revenues, "X," to equivalent constant dollar results by discounting "X" at the 10% inflation
rate to express all revenue in terms of year 0 purchasing power.
Then handle the time value of money by discounting again at the
constant dollar minimum ROR of 20%.
453
fi,+)(pFr1,oy
+ X(P/F1O,S)(P/FaO,S)
X
1-5
Revenue
-Development
-Depreciation
Taxable lnc.
-Tax @ 40%
Nei lncome
+Depreciation
-Capital Costs
Cash Flow
-50,000
-50,000
20,000
-30,000
_20,000
x-20,000
-.4X+ 8.000
.6X-12,000
20,000
-10Q,000
-130,000
.6X+8,000
2.991
20"/" escarated
Analysis
454
Note the four break-even results are all different. lt is very important
to explicitly understand the assumptions related to all economic analysis calculations to property interpret and appty the results for investment decision making. Break-even calculations are no exception..
Whether results relate to beforelax or after-tax calculations, done in
escalated or constant dollars, with or without risk adjustment, and on a
cash investment or leveraged basis are key assumptions that have a
significant effect on any proper economic analysis. Ther:e is no substitute for understanding the calculation mechanics and the meaning of
relevant discounted cash flow analysis assumptions in order to be able
to apply evaluation results properly for economic decision making.
Solution:
455
$4,200
=$10,000
Rev=$X
Rev=$X
Rev=$X
9e:$rqgq 1= $2,ooo
ACRS Depreciation
Using Table 7-3 Rates tor a7 Year Life Asset:
ltJodif ied
= $1 ,429
= $2,449
= $1,749
= $1,249
= $6,876
Value = $10,000 - 6,876
Year
fi.e.tenue
-Oper. Costs
-D+preciation
Taxable lncome
= $3,124
XX
-6,000
-3,000
-1,429 -2,449
X+2,000
-7,000
-1,749
-4,000*
-4,373
X-6,373
-rar_9192!
Net
-2.657
lncome
Depreciation
,429
2,449
1.749
4,373
549
" Final book value write-off and year 3 depreciation are combined.
Find break-ev)n revenue "X" per year to make NPV = 0 for i* = 2oo/o
0.8333
0 = -15,428 + (.6X-2,62O)(PIF2}"k 1) + (.6X
0.5787
+ (. 6X+549) (P I F 2g./",g)
0
= 1.2638X- 19,724.63
0.6944
3,501)(PIF2g"y",2)
456
iii;H6i'rilll i";"-;#ftrJffiil:[
1+i=(1+f)(1+i')
constant dollar break-even calculations and escalated dollar
breakeven calculations are equivalent if the appropriate rates are
used.
EXAMPLE 9-6 Expected Value Break-even Analysis
An investor has paid 9i00,000 to deverop a facility that is
esti_
mated to have a T1"k
of
successfuily
producing
s,000
product units per year -probabirity
1or each of the next e years, after which the
fa_cility is expected to be obsorete with a zero
satvate vatue. The
30% probability of fairure is associated with an escarat6d
doilar facirity salvage value of $s0,000 at year 1. Today's doilar
operating costs
are. $.4-0,0!0 per year and are estimated
to escalate t'SZ in year 1,
product seiling price is estimated
year
in
z.
?!9
10"/"
to escarate
25"h in year 1, and 1 s/" in year 2. Setermine the
required escarated
dollar selling price per unit in each of years 1 and 2 to give
the
investor a 12/" constant dollar expected DCFROR.
Assume inflation
will be 6"/"inyear 1, and 10"/"inyear 2. The
$100,000 cost will be
depreciated using Modified ACRS depreciation for a year
5
life starting in year 1 with a harf-year deduction. other income
Lxists against
which to use deductions in any year. The effective income
tax rate is
40"/" and all salvage coiisiderations are treated
as ordinary income.
Rev=5.969X(F/P25,1)
Op Costs=40,000(F/p1
Cost =
100,000
5,
457
5,000X(F/P25,
XF/P1 5, 1 )
P=A.7
Saivage = 0
Salvage = 50,000
To work in escalated dollars, which are the dollars shown on the
ciragram, we must calculate the escalated doliar minimum DCFRCR
for years 1 and 2 that are equivalent to lhe 12"/" constant doliar
DCFFIOR for the inflation rates of 6% in year 1 and 10% in yeat Z.
Year
50,000
Revenue
-Oper Costs
-Depreciation
-Write-off
-20,000
Taxable
-50,000
*Tax
7,187X-130,600
-2,875X+52,240
-30,000 3,750x-39,600
Costs -1 00,000
Flow
6,250x-66,000
20,000 -2,5AOX+26,400
Net lncome
+Depreciation
+Write-off
Cash
7,197X
-50,600
-32.000
-48,000
-80,000
@ 40o/"
-tQqpital
6,250x
-46,000
-20,000
20,000 20,000
80,000
4,312X-79,360
32,000
49,000
Expected PW Eq:
ri
i.
o.8425
0 = -1 00,000 + 70,000(P/F16.7,1)(.3) + (3,750X
0.842s
9,60OXPiF rc.2
\l
{|
$
t
0.8117 0.8425
+ (4,31 2X + 1,640)(PlF2g.2,lf lF1B.7,i(7)
X = $2'1 .77 per unit is the today's dollar selling price.
,l\(.7)
458
459
Year
Total Bevenue
lJet Revenue
-Wriie-off
-lDC s
900
324
500
216
400
144
-40
-.c2144X
-40
-40
-.02624X
-.03674X
-.065s9X
-.35X
lncome -.35X
Taxable
Tax @
40'h
.14X
Net lncome
+Depreciation
-32.4
_21.6
+.O2144X
+Write-off
+Depletion
+48.6
Cost
+.03674X
+32.4
+.O2624X
+.06559X
+21.6
-.15X
-.36X
Cash Flow
'
-48.6
0.8696
PW Eq: 0 = -0.36X + (189.9+0.00858XXp lF1g,1)
+
X
(1
0.7561
0.6575
18.6+0.01 470X)(P lF 15,2) + (71.0+0.03673XXp/F1
5,3)
460
lf the investor feels that 50% of well costs will be less than
$475,136, this investment appears satisfactory from an economie
viewpoint for the assumptions made.
9.6
461
difticult task sometimes. Different projects that on the surface seem similar
oi idendcal may have significantiy different development or operating costs
i.r
462
9.7 NPV
Net Present vatue (NPV) represents the additional afier-tax cost that can
be incurred at the point in time NPV is calculated ancl still give the investor
the minimum after-tax rate of return on invested. dollars. The woids ,addi-
463
"
1-4
Year
Revenue
-Oper Costs
20,000 20,000
-5,000 -5,000
-Development -i 0,000
-Depreciation -1,500 -3,000 -1,500
Taxable lnc.
-Tax @ 40"/"
-11 ,500
4,600
Net lncome
+Depreciation
-Equip. Costs
-'15,000
Cash Flow
-20,400 10,200
12,000
13,500
-5,400
-6,900
-4,800
7,200
1,500
3,000
8,100
1,500
9,600
+$9,860
464
lf you pay $9.86 million to acquire the property and the acquisition
cost is iax,.deductible as a patent cost,.as in,gsj" 1,.Npv- wilistill be
positive. You can afford to'pay *or. ihrn the NpV of
$9.86 ,ifii",
and still get a 20"/" DCFROR on invested dollars. This ]s.illustrated
now for an assumed $10 million acquisition cost considered amortizable over five years.
Year
Revenue
-Oper Costs
20,000
-Development
-Depreciation
-Amortization
-10,000
-1,500
Taxable
-Tax @ 40"/"
-11 ,500
4,600
Net lncome
+Deprec./Amort.
-Equip. Cost
-Amort. Cost
Cash
Flow
14
-6,900
1,500
-5,000
20,000
*5,000
-3,000
-2,000
-1,500
-2,000
10,000
11,500
-4,000
-4,600
6,000
5,000
6,900
3,500
-15,000
-10,000
-30,400 11,000
10,400
Although the NpV of the initial project was $9.g6 rnillion, spending
$10 million to acquire the patent rig-nts has still left the project with
positive NPV because of the patent tax deduction eifects. The
amount that can be paid for the patent to make project NpV zero is
calculated by expressing cash flow in terms of the before-tax acquisition cost, X. This is achieved by charging the project with a beforetax capital cost, X, at year 0 that is assumed to be amortizable
straight-line over five years (1 through 5) in this specific analysis.
This gives taxable income, income tax, net income, and after-tax
cash flows that are functions of the break-even acquisition cost, X.
Year
1-4
Revenue
-Oper Cost
-Development
*Depreciation
--A.mortization
Taxable
40%
Net lncome
-Tax
465
-10,000
-1,500
20,000
20,000
-5,000
-5,000
-3,000
-0.2x
-1,500
-11,500 12,000-0.2x
-4.2x
13,500-0.2X
= 0 = -20,400 -X + (10,200+0.08X)(p/A2g,a)
+ (9,600+0.08XXPiF2g,5)
0
= 9,860 -X + 0.09X(p/A2g,5)
we want the value of the acquisition cost, X, that will make the net
present value equal zero since that is the value of X that gives the
investor the minimum rate of return (zo% in this case) on invested
dollars, therefore:
X = 9,860 + 0.09X(p/A2g,5)
From the initial analysis we know 99,g60 is the project NpV without
any additional acquisition cost. From our own cash flow analysis we
can see that 0.08x is the annual tax savings from the annual amortization 'ieductions of 0.2X used to reduce taxable income that would
be taxed al a 4a/" tax rate. Therefore, in this analysis and in general
acquisition cost bi'eak-even analyses, it always works out that:
kind, not
determine break-even before-tax additional costs of any
For this analysis, ap-plying
iust for acquisition cost.Valuation analysls.
we can
Equation g-t, X = $12,970 or approximately $13'000' Now
five
over
amortizable
is
,,lritv that a g13,ooo acquisition cost, that
years, makes NPV equalto zero'
1-4
Year
20,000 20,000
-5,000 -5,000
Revenue
-Oper Costs
-DeveloPment
-Depreciation
-Amortization
-10,000
-1,500
Taxable
-Tax @ 4O'/.
-11,500
4,600
-3,000
-2,600
-1,500
-2,600
9,400
10,900
-3,700
-6,9.00 5,700
+Deprec./Amort. 1,5b0* 5,600
-4,300
6,600
4,100
,300
10,700
Net
lncome
11
. Capital cost is $15,000 depreciable equipment and $13,000 amortizable acquisition costs'
NPV = -33,400 + 11,300(P IAZO,+) + 10,700(PlF29,5) = O
cost'
The project DCFROR is 20% for the $13 million acquisition
of Year one
Case 2: After.Tax NPV Acquisition Analysis at the End
Aftertheyear0costsandyearlrevenuesandoperatingcost
for
have been incurred they are srht. Even the cash flows calculated
the
the initial project are not relevant to our analysis because
467
1 PW Tax Savings
0.8333
=
=
0.6944
0.5787
0.4823
0.2373X
468
the tax fficts for buyer and seller are offsetting. since sale value is always
taxable igc-ogle in the-.yprq;,-qf ttLe*ial-e" fhe.aequisition cost wogld have.tp,.bg
fully expensed in the year incurred for break-even acquisition cost ano ,ute
deducted over a period of time greater than one year, break-even acquisition
cost and break-even sale value are seldom equal. In general, this isi major
reasor that serious negotiations are often needed for buyers and sellers to
agree on a property sale value. Example g-ga illustrates break-even sale
value analysis.
what sale value at year 0 for the project described in Example 9-g,
Case 1, with after-tax NpV of $9,g60,000 would be economlcally a
break-even with keeping and developing the project? Assume the effective tax rate of 4o%is applicable forthe seller as it was forthe buyer.
$9,860, Y = $16,433
469
X-$9.BGC+0.4X
0.6X = $9,860, therefore, X = $16,433, identical with the break-even
saie va!ue.
9.8 lhluation
::
*'t
'ia
ii
u
i
i
i:
t:.
'&
citizens make far more requests and demands for service than monetary
rcsources permit carrying out. Therefore, it is very important that the best
possible use is made of available funds, so it is necessary to use an opportunity cost of capital minimum rate of return in evaluating public projects the
same as in evaluating private investment projects.
Determination of benefrts that will accrue to the public from investment in
various government projects such as roads, bridges, airports, dams and recreation areas is necessary to establish the relative desirability of projects under
consideration. It is, of course, difficult to determine all the public benefits
470
opportunity
if
cost of capital for public
prdject analysis is directly analogous to private
investment opportunity cost of capital.
9.9
471
472
well as net income possibly will occur in the next decade. In the early 1990,s
much more attention is being given by investors to cash flow earnings versus
financial net income earnings than was the case ten years ago.
current u.S. tax'law and Financial Accounting'standards Board procedures specify that for shareholder earnings calculation purposes
foi-nonmineral companies, straight line depreciation is to be used based on lives
of five years to thirty five years for personal property whire asset ACRS tax
depreciation lives range from 3 years to 20 years. Mineral companies use
units of production depreciation over the estimated producing lives of properties for financial shareholder reporting. similarly, general development
costs, mineral development costs and petroleum intangible drilling- costs
that are expensed for tax deduction purposes are deducted by units or production depreciation over the estimated production life of a property for
shareholder earnings calculation purposes.
EXAMPLE
9-9
A new company invested g440,000 last year in s year life depreciable assets. The assets were put into service this year and
$'100,000 was spent on the development of software products estimated to be saleable for the next 10 years. Sales revenue of
$500,000 and operating expenses of $gbo,ooo were realized this
year. Assume the effective company income tax rate is 40% and
determine the tax and shareholder reporting net income and cash
flow for this year. Assume the $100,000 colt wilt be expensed as
experimental development for tax purposes but amortized straight
line over 10 years for financial shareholder report purposes. MACRS
473
-Development
-Develop St Line, 10
Taxable lncome
-Corp. Tax @
-Deferred Tax*
yr
40"/"
Net lncome
+Depreciation
+Develop, St Line
+Deferred Tax
-Develop. Cap. Cost
Cash
Flcw
500
-300
Actual'Tax
Based on
Project Life
Deductions
500
-300
Shareholder
Statement,
Project Life
Deductions
500
-300
-88
-100
12
-S
-22
-22
_10
_10
168
168
_67
-5
-62*
7
88
101
101
22
22
10
10
62
-1 00
95
39
-1 00
95
" Deferred tax is the difference in actual tax paid and tax that would
be paid if straight line financial report deductions were used for tax.
Note that although cash flow is identically the same from both tax
and shareholder report calculations, the net income results are very
different. lnvestors looking at net income earnings as a measure of
economic success are likely to be more impressed with the g101
,000
shareholder report net income than the g7,000 tax report net
income. As long as brokers and common stock sharehorders continue to look at net income instead of cash flow as the basis for earnings per share of common stock calculations, it will be important to
public company managements to maximize net income reported
to
shareholders by using different financial reporting procedures than
tax reporting procedures.
tn
cash flow
seems inevitable that greater emphasis will be placed on
on
reporting to shareholders in th9 next dcade, gossibly with less emphasis
It
,i
operatingCashFlow=FinancialNetlncome+Depreciation+
Depletion + Amortization t Changes in
Working CaPital + Deferred Taxes
in
operating cash flow is the first of several cash flow numbers contained
a
shift
the shareholder report Consolidated Statement of Cash Flows' When
to greater emphasis on cash flow reporting from net income reporting
o".-r.r, it is likely that "operating cash flow" will be the cash flow that is
emphasized
Or = Operating CF
This is the basic project cash flow definition that we have dealt with
throughout the text to this Point.
Free Cash Flow
Applications
ATs
truly discretionary funds that could be pocketed without harming the businessi,Companies -with free cash flow can use il to boost dividends, to buy
back shares, pay down debt, acquire other businesses. or develop new pro.iects. Free cash flow is considered to be very desirable by both common
stock shareholders and potential company purchasers.
::l
l:
&
*
il
i
.'
,succegsful
in its first year of operation. One well was a dry hole costing
$100,000, the other was a producing oil well with intangible drilling
477
Tax
Shareholder Shareholder
(Accel.) (St.Line
Fi:yeiue
-3':
+aities
- Cp. Costs
-!DC
-Depreciaticn
:Qg$ lgpletro!
lbxable lncome
-Tax @ 40%
700
-1 05
700
-105
-70
*220
-10
-20
-70
-22
-70
-22
-70
-112
275
476
-110
-190
-7
-20
- Deferred Tax
Nel lncome
*Depreciation
+Ccsi Deplet.
-Deferred Tax
+lDC
_iL/U
-langible Cosis
-ilineral Rts Cost
70a
-1 05
700
-1 05
-7
-2A
476
-110
-110
-80
-44
232
-220
-70
165
286
10
20
20
220
22
286
7
20
80
22
-220
-70
-220
-70
-220
-70
--10c
25
-1 00
-7
-20
386
20
44
112
-1 00
-1 00
$0.165
$0.286
25
$0.286
25
$0.232
Cash Flow/Share
$0.025 -$0.055
$0.025
$0.025
-55
The accelerated tax deductions give smaller taxable income than straight line
deductions and this yields a smaller tax obligation and bigger cash flow. Cash
flow represents the net inflow or outflow of money each year so cash flow is
what management wants to maximize. which is why accelerated deductions are
takcn lbr tax purposes. Hou,ever, when brokers and common stock shareholders
around the world talk about eamings per share of common stock they usually
refer to net income earnings per share of common stock rather than cash flow
ealnings. \!'hen you look at net income earnings to evaluate a company you are
treating deductions for depreciation, depletion and amortization as out of pocket
costs in the amount deducted each year. This makes the method chosen to
deduct vzrious costs critically important to the net income eamings results that
will be obtained. Taking the straight line deductions shown in the second
478
column of the previous cash flow calculation table and using them for shareholder report eamings calculation purposes with full-cost accounting of drilling
costs gives bigger net income eamings than with successful efforts accounting.
The sirigle difference between full cost and succeSsful'efforts net income'calculation is in the handling of dry hole drilling cost. Dry hole drilling costs must be
expensed for shareholder reporting under successfitl efforts accounting while
such costs are capitaliTed and deducted by units of production depreciation
under full cost accounting. Comparing the full-cost accounting net income
earnings of $286,000 with the successful-efforts accounting net income earnings of $232,000 illustrates the difference for this example Note that the net
cash flow is identically $25,000 for both approaches and this is the same net
cash flow obtained with accelerated deductions for tax purposes. Most companies now evaluate projects (or other companies for acquisition purposes) using
annual cash flow projections over the life of projects. Unless general investors
adopt this cash flow analysis approach instead of looking at point value net
income eamings, it will continue to be necessary to deal vrith shareholder
reporting calculation procedures that are different from normal tax deduction
procedures. However, remember that it is what is done for tax purposes that
really determines when comoanies or individuals realize tax savings or incur tax
costs, so proper project analysis must be based on tax deduction considerations
and not shareholder eamings report deduction considerations.
9.10
based on
c)
straight-line depreciation.
Revenue
- Oper. Costs
- Depreciation
Taxable lncome
- lnc Tax @ 40%
Net lncome
+ Depreciation
- Capital Cost
Cash Flow
-10.0
-10.0
9.40
8.40
7.40
6.40
5.40
-3.50
-2.00
-3.50
-3.20
-3.50
-1.92
-3.50
-1.15
-3.50
-1.73
3.90
1.70
-1.56
-0.68
2.34
2.00
1.02
s.20
4.34
4.22
1.98 1.75
-0.79 -0.70
.1 I
.05
.92 .15
0.17
-0.07
0.10
1 .73
3.11
2.20
1.83
480
9.40 8.40
Revenue
- Oper. Costs
- Depreciation
-3.50 -3.50
-1.00 -2.a0
7.40
-3.50
-2.00
6.40
-3.50
-2.00
0.90
5.40
-3.50
-3.00
Taxable lncome
- lncome Tax 40"/"
Net lncome
+ Depreciation
- Capital
-10.0
ATCF
1:oo
1oo
1oo 1oo
,_oo
2.34
481
"2
2.34 1.02
9.00 6.40
1 .19
3.84
.05
2.30
1
0.10
0.86
11.630/"
SL Net lncome
Avg Book Value
ROCE
2.94
9.50
1.74
8.00
1.14
6.00
0.54
4.00
-0.66
1.50
alternatives. Over the years, Some have advocated using the third
year ROCE value as representing an overall average, but this is
:i ' ' '
rather arbitrary at
Another application of RocE is to calculate allowed return on reg'
utated investmenfs. Around the world, regulated utility investment
return is based on this type of calculation as discussed in Section
9.11 of this chapter. For regulated return analysis, allowed regulatory
deductions instead of tax deductions are the basis for analysis of
revenue and costs that may be received and incurred.
best.' '
AverageRoR=ffi
This technique was probably developed because investors recognized the futility of trying to utilize ROCE calculations in economic
decision-making. The application of this definition follows using
straight-line deductionsl
AverageROR=
=i|,'4/o
PW Eq:
DCFROR, i = 11.7"/o
483
484
definition of net income may vary among consultants. Some prefer one
accounting methodology vs another, capitalizing certain costs'versus
expensing, etc. Such issues are neglected in this Ciscussion. The annual cost
of capital may be calculated by taking.the cost of business assets times the
opportunity cost of capital. For most investors, after the first year, the
annual cost of capital is based on the remaining non-depreciated asset value,
similar to the denominator of ROCE. Again, the magnitude of the capital
asset basis will vary among consultants. The concept of "total annual cost
of capital" is really just an opportunity cost incurred when investors keep a
project, business venture or company and pass up selling the assets and
investing the after-tax cash flow at i*. This topic has long been addressed in
this textbook many years before the evolution of Value Added concepts in
the 1990's.
If VA is positive, it generally is stated that the project or business unit is
creating value or wealth for the company shareholders. Note that a business
unit with a positive VA is always directly analogous to a project with ROCE
greater than the financial cost of capital.
To illustrate how closely related ROCE and VA are, consider the following:
Net Income
ROCE =
Asset Book Value
'Asset book value" refers to the book value of all assets at the beginning
of a period (for either tax or financial shareholder reporting purposes) for a
corporation, but again; this definition can vary slightly for each consultant.
Rearranging the above inequality by multiplying each side times the
"asset book value" gives:
Net Income > i*(Asset Book Value), is satisfactory
trapter
485
This is the basic detrnition of value added provided earlier in this section.
Note the direct reiationship of this approach to the RocE calculation introriuced eariier. Further, you can see that successtul investors must generate
net income in quantities
-srearer than the product of the asset book value
rirnes rire opportunity cosr oi'capital il value is to be aticed to rhe portibliu.
while many compiinies may base these calculations on tinancial treatnlent o1'L-xpenditures - in his book, "The Quesr for \hlue," G. Bennett
slew'ait recomurend:i several modiiications to the tlnancial reporting procetlures iir order to make value added results more meaningfui in relationship
to casir liu,w. Some of the adjustments rvould include the ad.option of LIFo
inventory procedures, adjusting for deferred taxes. capitalizing of all R&D
and utiiizing full cost accounting so all R&D, development and exploration
e ,rirr-qes arc reflected in the capital base
- not just successful expenditures.
Such ari.lustmenrs are intended to allow operating costs to reflect actual
L'\pendirures for goods soid during the year. As was illustrated in chapter g,
ir: inflirtionary rimes, the LtFo methodology vzill lower taxable income and
tax, rvhich increa.ses cash flow and value when compared to the FIFO
approach. stewart argues that by making his recommended adjustments, the
asset book value lvill more clearly represent actual value of expenrlitures
incurred and hence. the true investnrent required to generate the revenues
realizc'd for the year. Such adjustments rvould be u'elcome, but may still not
prot'ide a halance sheet or net income statemeni that rellects the true market
raiue. wlirch is u'hat true opportunitl co,t is based on.
If \A or RocE are to be used for economic decision-making, three considcrations should be addressed in attempting to capture the true measure of
value being added. (1) tax deductions, rather than shareholder report hnancial deductions, must be the basis of the analysis so that net income is based
on actual tax paid, not an accrual based on straight line, project life depreciation. This can also be accomplished by adjusting the financial net income
for deferred tax considerations. (2) rhe opportunity cost of capital, rather
than the financial cost of capital must be utilized. opportunity cost of capital repre.sents the rate of rerurn potentiai for those other opportunities that
exist for investment of funds. Investors don't want to accept investments
that simply achieve the financial cost of capital, so why should the value
added opportunity cost calculation be any different? As discussed in chapter 3, section 3.J, use of financial cost of capital as a minimum rate of
return will show investors the projects that will make money for them, but it
is necessary to use opportunity cost of capital to determine the investments
that generate maximum value possible from available investment capital
486
I
I
T
1)
VA forces managers to think about the balance sheet and the assets
that are under their control and to what extent those assets are being
utilized. However, thii is the basic axiom of opportunity cost as advocated by these authors for years. So while certainly not new in concept, VA may provide a different approach to understanding this
important evaluation consideration. There is a cost to holding idle
plant facilities, working capital or other non-performing assets.
2)
3) VA and ROCE provide a short term indicator of the economic performance of business units involving many combined projects that would
involve much effort to analyze for the life of a project with discounted
cash flow. However, if VA or ROCE results indicate change is needed,
$
I
Ct:"nIer9:After-TaxlnvestmentDecisionMethodsandApplications
aa7
to
discounted cash flow analysis should be done for the business unit
to
due
generation
flow
evaluate_ the economic impact on future cash
with
selling
p.oposed crrrrent changes and how those results compare
or ihutting down. This analysis should be based on market value
0oportunitv costs and an opportunity cost of capital discount rate, not
linarrcial reporting book values and financial cost of capital.
4)
\A
as
abasistoevaluatemanagerialperformance.Discountedcashflow
a
analysis isn,t very useful for this purpose since it typically Co\'ers
improvements
rewarding
tonger period. Generally, the basis for
given
should not be associated with the absolute value added in any
period, but on whether value added can be consistently increased over
aperiodoftime.Thiscanhelpavoitlshortrunmanagementdecisions
to sell now or defer capital expenditures for the big bonus this year,
tiren rvorry about the future later. often it's not easy to compare mantwo
agers fairly using the vA for a given period. To illustrate, suppose
a
3g-year-old
operates
one
company,
,iunug"r, *ork for the same
fully depreciated plant while the other manages a recently upgraded
faciiity.Theopportunitycostschar.gedagairistnetincomervillmost
tikely be highei for the newer plant given the recent capital expenditures.However,thatdoestl'tnecessitrilymeanthenewpiantmanager
is urtder-performing compared to the old plant manager' By comparingtherelativechangeinvalueaddedo.;ertime,eachmanagerwill
be evaluated on a Inore level playing field'
,-----
488
Year
Revenue
- Oper. Costs
- Depreciation
Taxable lncome
- lncome Tax 40,/"
Net lncome
9:40
8.40
-3.50 -3.50'
'
7.40
-3.50
6.40.'
-3.50
5.40
-3.50
-1
The book value necessary for calculating the annual cost of capital, or annual opportunity cost, is based on the book value of the
assets at the "beginning" of each year which is summarized below
per the use of straight-line depreciation:
Year
Beg Book Value
10.00
9.00
7.00
5.00
3.00
(Book Value)(i-=12%)
Net lncome
+Deferred Tax
-Cost of Capital
Value Added
2.94
0.40
-1.20
2.14
1.74
0.48
-1.08
1.14
PV @ 1 2%
- 2.1 4(P lF
Z"/",1) +
1 .1
4(P lF
489
Z/.,2\ + 0.27 (P lF 1 2% S)
For all the extra effcrt, the resuiting present value of the value
added each year is the same measure of perfcrrnance that is utillzed
by most corporations and individual investors alike, l",lPV! But a
downside of this concept is the focus on a net income based criteria
which may force the early closure of this project at the end of year 3
or 4 depending on whether the focus is value added oriented or cash
flow oriented. This project continues to generate positive cash flow,
which is adding value and generating the NPV of 1.889, yet VA or
FIOCE would demand suspension of the project before its full value
may be obtained!
EXAMPLE 9-12a Vatue Added Using Tax (MACRS Depreciation)
Rather Than Financial Shareholder Deductions
Revenue
- Oper. Costs
- Depreciation
Taxable lncome
- lnc Tax @ 40%
Net lncome
Beg Bk Value
Cost of Cap @ 12"/"
Net Income
- Cost of Capital
Value Added
9.40
5.40
-0.21
490
Due to limited space, VA is rounded above, but more detail is provided below in the present worth equation:
PW EQ: 1 .14(PlF 12/"J,) + 0.06(P/F
12"/",2) + 0.61 2(PlF1Z%,g)
+ 0.7 O44(P lF p/o,4) - 0. 1 OSO(P /F pt,S)
9.ll
sonable" for regulated investments from the viewpoints of both the public
purchasing a product and the investor producing or transporting the product.
The regulatory commissions must walk a narrow line to determine regulated
investment rates that are adequate to permit a company to stay in business
and provide the needed service, but not permit rates that would give exces-
sive return on investment from the public viewpoint. In other words, the
regulatory commission strives to set regulated rates that do not cause
"undue discrimination" nor give "unjust preference" to the consumer, to the
investor, and to the general public interest.
The terms "revenue requirement" and "cost of service" often are used
interchangeably in referring to the revenue that is required to cover all costs
for providing a service and to give the investor an adequate return on investment. In equation form:
Revenue Requirement Per Year =
Eq.9-2
491
duce here.
Eq. 9-3
Equity Investment
R-ate Base
of the common
Eq.9-4
Eq.9-5
tq
492
if Applicable
Interest on Debt
= Taxable Income
:ffil"i"li"
Computer / Electronic Equipment
Producing Equipment / Gathering Lines
Transmission Pipeiines / Storage Fac.
yr
yr
15 yr
5
7
#:Ji:r$"
10
yr
Units of Prod.
29
yr
493
PROBLEMS
9-i
it at that time?
B) What is the undiscounted payback period?
c) \\'hat is the constant dollar DCFROR assuming 107o inflation per
year?
9-2 An independent
,s
xi
sil
E
petroleum company with existing petroleum production in excess of 1.000 barrels per day acquired the mineral rights to a
property 2 years ago for $400,000. The property was drilled this
r.lonth (year 0) for intangible drilling costs of $600,000. The geologicul evaluation of well logs indicates that completion of the well is
associated with a 607o probability of producing 40 banels of crude per
clay, u,ith a price of $30 per barrel during the first year (350 producing
days) of production (assume to be year 1) with a 40Vo probability of
producing nothing and realizing a net abandonment cost and producing equipment salvage of $100,000 income at year 1. The new well
producing equipment and tangible completion cost would be $200,000
at year 0 with a $100,000 intangible completion cost for fracturing
well to the royalty owners for $350,000 cash at year 1 including all
producing equipment and mineral rights. Modified ACRS depreciation
over 7 years will start in year 1 with the half-year convention on tangible costs. Other income and tax obligations exist against which to use
the year 0 intangible drilling cost (IDC) deductions. The effective tax
rate is 40Vo and any gain or loss on the sale is taxed or deducted as
ordinary gain or loss. Royalties are ISVo of crude oil revenue and production operating costs are estimated to be $60,000 in year 1. Neglect
any windfall tax. For a minimum escalated dollar DCFROR of 207o,
use Expected NPV Analysis to evaluate if the well should be completed or abandoned at year 0, assuming the well will be sold at year 1
if completed
9-3
A petroleum company wants you to evaluate the economics of abandoning a stripper oil well versus selling the well to an interested
investor. If the well is abandoned, a $20,000 abandonment cost must
be incurred now (year 0) and a salvage value of $30,000 will be realized on the used producing equipment. $5,000 of book value remains
on the producing equipment and will be written-off against the salvage
9-5
495
the
development rights to a property for which an offer of $1 million cash
will
496
9-8
9-9
escalation of operating costs each year which start at $50,000 per year
in year 1 and increase $10,000 per year. The initial invesrment will be
depreciared over 7 years using Modified ACRS depreciation, starting in
year 0 with the half-year convention. Assume a zero salvage value. The
effective income tax rate is 40va. what break-even sales revenue is
needed each year to yield a2570 DCFROR on invesrment dollars?
9-10 Project costs, sales and terminar value for a 6 year life.project are
shown on the time diagram in thousands of dollars. Assume all costs
and rer.'enues are in escalated doilars and assume a wash-out of escalation of operating costs and sales revenue in each of revenue-prod*cing
)'ear:i 2 through 6.
Cyork 6ur=$200
The salvage value is for u,orking capital return and depreciable asset
salvage. Expense research and expenmental development iosts at years
0
and 1. Assume other income exists against which to use negative taxable
income in any year. Depreciate capital equipment straighl line over
5
-r'ears
sr,arting in year 1 with a hait'-year deduction. The effective income
tax rate is 40va. use an escalated dollar minimum DCFROR of 15% ancl:
A) Determine rvhether project economics are favoreble using Npv
analysis.
B)
c)
D) what
E)
498
9-11 Using the net incorne generated in Problem 9-10, Case A, calculate the
. ., annual,:lvalue..addedil in"years2.through 6 and,then determine the
overall present value of the value added. Use the same after-tax opportunity cost of capital of 15% and neglect deferred taxes-assuming the
investor has used the slower straight-line deductions for tax as well as
financial reporting so there is no difference.
9-12 Evaluate the economic potential of the project described in problem 910 if the research at time zero has a 40vo probability of success, and if
success leads to the end of year I development, equipment and working
capital costs which yield a process with a 707o probability of success
that results in the year 2 through 6 sales and salvage value given.
Assume that, if the year 1 investment is a failure, at the end of year 2 the
working capital return of $200,000 will be realized, and a write-off of
the $500,000 depreciable cost will be taken against other income.
Assume that if the time zero research fails no salvage is realized. '
9-13 Work problem 9-10A for the situation where sales per year are
unknown instead of $900,000 per year and determine the selling price
per unit for sales of 10,000 units per year to give a l57o ptoject
DCFROR. Assume that escalation of the selling price per unit after
year 2 will be sufficient for sales revenue increases to washout any
operating cost increases, that is, you will be calculating the yeat 2
break-even selling price per unit and it will escalate in following years
to cover cost increases.
9-14
ltis
499
against rvhich to use tax deductions and tax credits in year 0, but that
othcr income will exist in year 1 against which to use possible failure write-off dedLrctions. Assume the effective tax rate is 40vo.For a
constiint rlollar minimum DCFROR of lovo and inflation rates of 6vo
in 1'ear 1,8.otb inyear 2 and l0%o in year 3, calculate the constant dollar expected NPV for the project. verify that escalated dollar
expected NPV equals constant dollar expected Npv by calculating
the escalated dollar expected NpV.
9-15 A natural gas pipeline to transport gas from a new gas well would cost
our company $220,000 with operating costs of $5,000 per year pro_
jected over rhe 6 year project life. The XyZ pipeline company has a
gathering line nearby and has offered to transport our gas for $0.10 per
)\{CF (thousand cubic feet of gas) by spending $50,000 to build a
gathering line to connect our well to their existing line. To determine
whether $0.10 per MCF is a reasonable transport charge, calculate the
break-even price per MCF transported that would give our company a
12c;?' DCFRoR or.r the $220,000 pipeline investment for the following
production schedule and modified ACRS depreciation for a 7 year
lir'e staning in year.l with the harf-year convention on the pipeline
cost. use mid-year average production and time value of money factors. Assume a 40vo income tax rate. Neglect any opportunity cost
from the forgone sale cash flow in this break-even development cost
analysis.
Year
0.5
1.5 2.5
3.5
4.s
5.5
Annual Prod.
hI},{CF
150
500
mine life is estimated to be 5 years. Mine equipment will be depreciated over 7 years using Modified ACRS rates, starting in year 0 with
the half-year convention. Salvage value and working capital return
will be $5 million at the end of year 5 with any taxable gain taxed as
ordinary income. The effective tax rate is 407o. Coal reserves are estimated to be 5 million tons and production for years 1 through 5 is projected to be 1 million tons per year. Coal selling price is estimated to
be $30 per ton in year l, escalating l07o per year in yeats2 through 5.
Royalties arc 8Vo of revenues. Mining operating costs are estimated to
be $12 per ton in year 1, also escalating by 70Vo per year in following
years. 1) Calculate the project DCFROR and NPV for a minimum
DCFROR of 207a to determine if the mine development economics are
preferable to selling assuming that we have an offer to sell the coal
property at year 0 for $20 million cash with any gain taxed as ordinary
income. 2) Calculate the sale price that will make selling a break-even
with development. 3) Finally, calculate the year 0 mineral development cost incrementally in addition to the $10 million dollar cost in
the analysis that would just give the investor a 20Vo DCFROR on
invested dollars.
9-17 Your integrated oil and gas company owns a l00Vo working interest in
a lease. To develop the lease, two alternatives are considered:
Case
Case
B.
Year zero intangible drilling costs are estimated at $250,000 while tanbe
$100,000. Start amortizing 30Vo of the IDC in year 0 with a 6 month
'al'renr taxes)' oir prices are torec.sted to t,e $20.00 per hanel in
!cirr 1 a*d 2 and then escalate 5.07c per year in each of ylars
3 and 4.
Production is irr banels, and is estimated io be
as foltows:
Production
Year
01234
t)-18 An integrafecl
oir and gas producer has an existi,g gas well with
curnuiarive production to dare o1,2.0 Bcf (bilrion
crt,iJfeetl rvith an
ttltitnette reco\rery of approximately 2.6
Bcf. An in-fill well is being
co,sidered that
will
502
Existing
Yt,
0
I
2
3
4
5
Gas
Well
New
Gas
Existing
Modified
Well Existing
Selling
Well
Annual
Well
op.rcotti
produrtion
. op.rcort
The after-tax escalated dollar minimum rate of return is rz.Tvo and the
net of salvage and abandonment cost is estimated to be zero. The
effective state and federal tax rate is 31.0vo. Assume other income
exists against which to use all deductions in the year they are incurred.
Determine whether the "in-fill" well should be drilled using ROR,
NPV and PVR analyses.
9-19 Two years ago, a chemical company acquired patent rights to a new
product manufacturing process for a cost of $2.5 milion dollars. The
total cost is still on the books but will be amortized uniformly over a 5
year life beginning in year I if the project is developed. Today, (time
zero) the company is trying to determine whether to keep the patent
rights and develop the process or to sell it to another firm for a cash
offer they have received of $4.5 million. If the company should elect to
develop the process, experimental deveropment costs of $12 million (to
be expensed for tax purposes) and equipment costs of $15 million will
be required today, time zero. The year 0 equipment cost will be depreciated by MACRS over a 7 year recovery period with the half year convention beginning in year 1. write-off the remaining book values at the
end of year four when the project is terminated due to declining market
demand for the product. The capital expenditures are expected to have
an 80.07o probability of generating revenues of $25.0 million and operating costs of $ 10.0 million in each of the next four years. Escalation of
revenues and operating costs is assumed to be a washout so assume the
same profit margin is maintained each year. If the project tails (probability = 20.0vo), the equipment can be sold net of abandonment costs
503
lor $ l0 million in year 1 and the patent and equipment costs written off
at that time. Assume other income exists against which to use all
deductions in the year incurred. The effective tax rate is 38.OVo.'
flevelop:
C ' >>l
of
Patcnt =
S2.5
Dev. = 512.0
Equip. = $15.0 P = 0.80
Rev. =
P = 0.20
Sell:
lost of
Patent =
$2.5
Sell = $4.5
-2
....4
A)
B)
9-20 A gas pipeline manager has determined that he will need a compressor
to satisfy gas compression requirements over the next five years or 60
months. The unit can be acquired for a year zero investment of
$1,000,000. The compressor would be depreciated over 7 years, using
MACRS rates and the half-year convention, beginning in year 0. The
cost of installation at time zero is $75,000 and a major repair cost of
$225.000 is estimated at the end of year 3. Both the installation cost
and the repair cost r',,ill be expensed in the evaluation year they are
incurred. The compressor would be sold at the end of year five for
$300,000 so write otT the remaining book value at that time. The alternative to purchasing is to lease the machine for a year 0 payment of
$7-5,000 to cover installation costs and beginning of month lease payments of $24,000 per month for 60 months. Lease payments include
all major repair and maintenance charges over the term of the lease. A
balloon payment to purchase the compressor after the fifth year is not
being considered since the compressor is not expected to be needed
after the specified service life. This is an operating lease so expense all
lease costs like operating costs. The.after.tax, escalated dollar,,nomi-
9-21
A new $10,000,
10 year
the following: (A) After purchasing the bond, if market interest rates
instantly increased to 10.0Vo, or decrbased to 6.080, how would the
bond value be affected? (B) If the bond has a 30 year life instead of a
10 year life, how do market interest rate changes to 10.07o or 6.0Vo
affect the value? (C) If the 30 year 8.0Vo bond is a new $10,000 face
value (year 30 maturity value) zero coupon bond instead of a conventional bond, how is value affected by the interest rate changes?
CHAPTER 10
10.f
Replacement of existing assets with new and usually more capital intensive
assets is the most comrnon service analysis situation. Replacement of physical
assets usually is considered for cne of three general reascns ( i ) the present
asset is inadequate for the job, for instance, more capacity may be needed;
(2) the present asset is worn out or physically impaired causing excessive
maintenance or deciining efficiency and; (3) the present asset is obsolete,
that is. improved assets are available ttrat do the job more efficiently.
In engineering economy literature related to replacernent, the present asset
sometimes is described as the "det'ender" and the proposed new asset is
called the "challenger". This appropriately describes the alternatives in
replacement studies, but whatever the altematives are called the most important aspect concerning replacement is that it should be based on asset performance economy and not on physical deterioration. There frequently is a
reluctance on the part of managers to replace physically satisfactory equipment even though economic savings will result from the replacement. Financial and intangible considerations often get entangled with the economics of
the replacernent of equiprnent. Sometimes managers state that it is not economical to replace equil:ment at this time u,lien thel' mean tirat from an economic viewpoint the replacement should be made now, but because of financial and intangible considerations the replacement will be defered. It is quite
important to separate economic, financiai, and intangible considerations to
get the final replacement decision in proper perspective. This generally will
result in more decisions based on the economic viewpoint.
Intangible replacement considerations may include the relative risks and
uncertainties involved between alternatives. Economic analysis of replace505
506
ment alternatives usually is based upon the assumption that risk and uncertainty. are similar fqr.the different alternatives under ,consideration. This
may not be the case. Old assets when compared to new assets have relatively lower capital cost, shorter life and higher operating cost and, there-'
fore, relatively lower projection risk and uncertainty. If the projected annual
costs for an old and new machine that will perform the same service are
equal the intangible difference in the risk between the two alternatives may
sway the decision to the old asset, although that is a relative judgement on
the part of the evaluator and managers involved with the decision'
Replacement analysis does not require any new engineering economy
decision methods techniques. The techniques of ROR, NPY PVR, annual
worth, present worth, future worth and break-even analysis applied after tax
considerations are the decision methods used for a large majority of industrial replacement analys es. From a practical viewpoint, you can think of all
investment decisions as being replacement decisions concerning whether to
replace a present asset or investment opportunity yielding some minimum
rate of return with'another investment that promises to give a higher retu.rn
on investmelz, (or lower annual cost, present cost or future cost if the same
service is perfbrmed). In most replacement situations such as cornparing an
old and a new asset the tax deduction advantages differ greatly between
alternatives. In almost all cases replacement analyses should be made after
tax to obtain valid decision-making results. Before-tax analysis can lead to
incorrect economic decisions because tax considerations often are very different between replacement alternatives being evaluated. Example 10-1 illustrates the after-tax application of five primary analysis methods utilized in
industry practice for comparing alternatives that provide a common service.
The installation of automated equipment costing $60,000 is proposed to reduce labor and material costs for an operation over the
next four years. The equipment would be scrapped at the end of four
years. Labor and maintenance operating costs with the new equipment are expected to be $10,000 in year one, $12,000 in year two,
$14,000 in year three and $16,000 in year four in escalated dollars.
The operating costs per year under the existing labor intensive mode
507
Solution:
A and B) For incremental DCFROR and NPV analysis, the easiest
solution approach is to examine the incremental differences between
the alternatives before-tax, then account for the tax considerations
on the incremental costs and savings to get after-tax costs and cash
flow. This analysis approach follows:
Before-Tax Diagrams, C=Cost, QQ=Operating Cost, $=Savings
New
C=$
1
34
'ooo
ord
0
New c=$60,000
34
S=$30,000
s=$30,000
S=$30,000
S=$30,000
-old
It was shown in chapter 3 that negative incremental operating
costs are the same as positive savings. The savings of $30,000
508
Year
-2
30,000
Savings
30,000
-10,496
"3
30,000
"
-7,497
30,000
-Depreciation -8,571
-14,694
15,306
19,504
-6,122
-7,902
22,503 11,259
-9,001 -4,503
+Depreciation 8,571
9,194
14,694
11,703
10,496
13,502
7,497
6,755
19,742
25,497
Net
lncome
-5,143
-19,742
+ 20,999(P/F1,3) +25,497(PlFi,4)
Compared to i* = 20"/" it'r escalated dollars, this is a slightly satisfactory incremental investment, indicating accept the new equipment. Getting 22.9% DCFROR is slightly better than getting a2O"/"
DCFROR in other projects. (Note that if you make a before-tax analysis, the $30,000 savings per year give a 34.9% before-tax ROR on
the $60,000 initial investment which possibly could lead to a different
economic conclusion, depending on the before-tax minimum ROR
used. Analyses must always be done after-tax to be valid.) NPV
analysis verifies the DCFROR results:
0.8333
0.6944
NPV @ i* = ZC,/o= -56,571 + 23,878(P /F 2Oh,1) + 22,198(P lF 2g"/",2)
0.5787
o.4823
(P lF
(P
+
25,4e7
tF 2s"/",a)
2sy",s)
=
il:?31
509
Year012
Revenue
-Op. Costs
-Depreciation -8,571
-10,000
-14,694
-12,000 . -14,000
*10,496 -7,497
-16,000*
-18,742
-34,742
8,599
13,897
Net lncome
-5,143
+Depreciation
8,571
Cost
-Capital
-60,000
-14,816
-13,497 -12,898
-20,845
Cash Flow
9,878
-56,57'1
14,694
-122
8,998
10,496
7,497
-3,002 -5,401
18,742
-2,103
0.6944
0.8333
PW Cost NEW = 56,571 + 122(PlF2a/"J) + 3,002(P/Fzo"/",2)
0.4823
0.5787
+ 5,401 (P/FZA%,3) + 2,103(PlF2g"/",4)
= $62,g9g
0.3863
AC ruEw = 62,898(A/Pzo"k,q) = $24,297
The sign convention used in both the present worth cost and
annual cost calculations is that negative cash flow is equivalent to a
positive cost and positive cash flow is equivalent to a negative cost.
510
Year012
4'
Revenue
-Op.
Costs
Taxable lncome
*Tax @
40"/"
Net lncome
-Capital Costs
Cash Flow
0.8333
0.6944
PW Cost OLD= 24,000(PlF2O"/o,1) + 25,200(P1F2q"1",2)
,
AC
oto
0.5787
0.4823
+ 26,400(PIFZO%,3) +27,600(PlF2gy",4) = $66,088
0.3863
66,088(A/Pzo/",+)
=
= $25,530
511
1,000x
4
1,000x
-16,0C0
-18.742"
1,000x
1,000x
-12,000 -14,000
-10,496
-7,497
-10,000
-Depreciation -8,571 -14,694
Taxable lncorne -8,571 1,000x
1,000x
1,000x
-24,694 -22,496 -21,497
-Tax @4A"h +3,429 -400x
-400x
-400x
+9,878
Net
lncome -5,143
+Depreciation
+8,571
+8,998
600x
1,000x
-34,742
-400x
+8,599
+13,897
600x
600x
600x
:aeprlel9e$ -60,000
Cash
Flow -56,571
600x
-122
600x 600x
-3,002 5,401
600x
-2,'103
0.8333
0.6944
PW Eq:0 = -56,571 + (600x -122)(P1F20,1)+ (600x-S,O02XP/FZO,Z)
+ (600x
0.5787
5,401)(P/F2p,3) + (600x
4.4823
2,1O3XPlFZO,q)
512
The ratio of break-even cost per unit of service for new compared
to old is the same as the ratio of present worth cost of service for
new compared to old or the ratio of annual cost of service for new
compared to old, so the same economic conclusions must be
reached with all of these criteria. ln this case the conclusion is to
select the new alternative.
An analysis situation that sometimes makes it advantageous to use cost
per unit of service analysis instead of present worth cost, annual cost or
incremental NPV or ROR analysis is when estimated service to be received
from year to year changes with different assets due to considerations such
as different maintenance and major overhaul schedules on equipment.
Assuming the full service that can be provided by different alternarives is
needed and can be utilized even though it is not the same from year to year
for different alternatives, break-e.ren price per unit of service produced is a
convenient method of fairly cornparing the alternatives without having to
lay out the time diagrams for each alternative to give the same service per
month or year as well as for the same common study period (evaluation
life). When service differs from period to period with different alternatives,
but the full service of any alternative can be utilized, it can be very difficult
or physically impossible to make projections to compare fairly present
worth cost or annual cost for providing the same service per period and
cumulatively over the evaluation life with each alternative. In this situation,
513
the evalua_
'ion lit'e. ldowever, it is t'en,intportant to note that break_even cost per unit
1'.1 'ser,ice analvsis irtrp!icitly assumes
that tlte.full service of each alterna_
t!ve ctin be utiliz.ed each period (such as ayear) e,-en thottgh
service rnay be
,li.ifbrent with each altenrutive
from period to period.
10.2 Leasing Compared to purchasing
Leasing
514
tion, or simply eliminate the need to borrow money to purchase. From a corporate viewpoint, i1,,14ight mean other corporate cash could be invested elsewhere in the company where it can generate income or create savings and
515
516
with the lease. This discounted depreciable cost basis may be greater or less
than the cash purchase price. The.discount rate used to establish the depreciable cost basis is not the opportunitl' cost of capital. Instead, the applicable
discount rate is specified to be reflective of curuent or prevailing equivalent
barrowed money interest rates available in the marketplace. The IRS pub'
li,shes a schedule of applicable rdtes each month for use in these calcula'
tions. These are semi-annually compounded nominal rates referred to as the
"Applicable Federal Rate" (AFR). There are short, medium and long term
AFR's so you must select the one that best matches the lease term. If you
are using annual evaluaiion periods you should convert the semi-annual
period AFR to the equivalent effective annual rate using text Equation 2-9
developed in Section 2.3 in Chapter 2.lf you can prove your cost of bonowing is less, the lower rate may be allowed. Remember, a lower interest rate
will result in a larger cost basis and bigger depreciation deductions, sheltering more income from taxation. However, the imputed interest component
of the capital lease payment is deductible in the period as well, so a smaller
interest rate will reduce the allowable interest deduction.
"Leveraged leases" vary from operating and capital leases in that a third
party becomes involved in the arrangement. Assume a company has a need
for equipment in an ongoing operation. However, the lease terms offered by
the equipment dealer are too expensive. Instead of negotiating directly with
the equipment dealer, the company might go to a third party and negotiate a
lease. The third pa(y would then acquire the equipment and lease it back to
the company. This acquisition may involve the third party going out and
soliciting funds from other banks or lending institutions, often on a nonrecourse basis, to finance 607c to 80Vo of the purchase price. The third party
vnottld put up the balance. The lending agencies recourse in the event of
default would be through various liens, etc., on the actual equipment. Leveraged leases are used for equipment in all industries including aircraft, buildings and electric generating plants. These lease arrangements could be
structured as either capital or operating leases.
Remember, lease payments, interest and depreciation only qualify as
tax deductions when the asset is held or used for generating income. If a
business application does not exist, the costs are certainly still relevant,
but in most circumstances, no tax deductions are available. This means
from an individual viewpoint, such analyses are often made on a before
tax basis. IRS Publications 17 and 917 may be helpful in identifying specific tax questions if the asset in question is used for both personal and
business applications.
Analysis
S1Z
Summary of the Economic Evaluation Differences Between an Operating Lease and a Capital Lease
Operating Lease (Rental Agreement)
.
r
bcrrowed funds published by the IRS at the time the lease is initiated.)
The present value of the capital lease payments (discounted at the same
imputed interest rate previously described) may be depreciated over
The following tax rules offer guidelines for determining whether your
lease might be considered as an operating, or capital lease. In the absence
of
518
7) Total rental payments plus option price approximates the value for
which the property could have been bought, plus interest and carrying
charges.
8) Tire lease may be renewed at nominal rentals over the life, of the
property.
Some authors have advocated that the economic evaluation of whether to
lease or purchase an asset is really a "financial" decision. As a financial
519
sis on either a present, annual or future basis can be used. With this
approach the objective is to minimize the cost of service between ieasing or
purchasing. Second, an incremental approach to assess the economics of the
additional investment required for the more capital intensive purchase alternative over leasing can be used. Larger up front investments generally mean
lower downstream operating costs and the reduction in such costs are the
savings available to payoff the additional up front costs. Incremental evaluations typically rely on rate of return, net present value, or ratio analyses.
520
A)
Cash Purchase
B) Operating Lease
C=350
L=1 50
LP=69
LP=129
LP=69
C) Capital Lease
521
LP=100
LP=200
L=1 50
LP=100
D) Leveraged Purchase
B=280
C=350
L=1 50
MP=159
MP=159
* Tax @ 4C%
Net lncome
+ Depreciation
- Capital Cost
Cash
FIow
150.0
-70.0
-70.0
-112.0
-112.4
-168.0
*18.0
28.4
44.8
7.2
*42.0
-ot.z
-10.8
70.0
-350.0
-322.0
112.O
168.0
44.8
157.2
Year
0.0
Sal,yage
- Lease Payments
Taxable lncome
- Tax @ 40%
Net lncome
- Capital Cost
Cash Flow
PW Cost @ 15.O% =
-60.0
*60.0
-120.0
-60.0
-60.0
24.0
-'120.0
48.0
-36.0
-72.0
-36.0
-72.0
-36.0
24.0
0.0
-36.0
-125.8
522
2"
150.0
- Depreciation*"
Taxable lncome
- Tax @ 40%
Net lncome
+ Depreciation
Cash Flow
-74.0
-74.0
?e.6
44.4
74.0
*70.4
-24.0
_rig.0
-8.0
_rz6.o
-142.0
56.8
_34.0
-85.2
118.0
13.6
-20.4
176.0
_92.0
-143.2
63.6
PW Cost @ 1S.O% = -146.g
* lrnputed
lnterest payments @ g.O%
*n
PW cost of capitar Lease payments (Depreciabre
Basis):
PW Cost = 100 + 200(p/F9 yo,1) + fia(pFgy",Z)
= $3Oe
Yr
Yr
Yr
0
1
2
Payment
100
200
100
lnterest
0
24
Principal
100
176
92
Balance
268
92
0
Year0lz
Salvage Revenue
- lnterest
- Depreciation
Taxable lncome
- Tax @ 40%
Net lneome
+ Depreciation
+ Loan Amount
- Principal
- Capital
Cash Flow
_25.2
-70.0
-70.0
28.0
*42.0
70.0
280.0
Payments
Cost
-950.0
PWCost @ 15.0%=-130.2
-112.0
-137.2
54.9
-82.3
112.O
_134.0
0.0
150.0
-13.2
-168.0
-31.2
12.5
-18.7
168.0
_.146.0
0.0
523
Balance
280.0
146.0
0.C
Lease
OC=$3,500 OC=$1,750
OC=$1,500 OC=$2,000
---ac=$1,ooo
L=C
524
s=1.75 S=3.5
S=1.75 L=2.0
Net
O.Sz
Z.BB
2.87
Cash Flow
3.40
-8.15 3.38
*
The book value write-off and year 3 depreciation are combined.
A) lncremental DCFROR Analysis
PW Eq:0 = -8.15 + 3.38(P/F;,1)+ 2.87(plFi,2) + 3.40(p/F;,3)
525
-Op. Costs
-1.00 -1.50
-Depreciation -2.00 -3.20 -1.92
Taxable lncome -2.00 -4.2O -3.42
2.OO
-2.00
-2.88
-2.88
0.80 1.68 1 .37 1 .15
-Tax @ 40"/"
Net lncome
-1.20 -2.52 -2.05 -1.73
+Depreciation
2.AO 3.20
1.92 2.88
Costs
-Capital
-10.00
Cash Flow
-9.20 0.68 -0.13 1.15
526
Year
Revenue
-Op.
Costs
Taxable
0.7a
-Tax @ 4O/"
Net lncome
-Capital Costs
Cash Flow
1.80
2.00
-0.7S
-3.75
1.50
PW Purchas = 9.20
0.8696
0.7561
0.68(p/F 15"/o,1) + 0.13(p1F67",2)
- 1 15(PP?il"l.'
=
7.9S
0.8696
0.7561
PW Lease = 1.05 + 2.7O(plFl1o/o,1) + 0.00(p/FlS.t",Z)
0.6575
+ 2.25(plF1S"/"p)
=7.15
- (-2,15) = -0.g0
527
These are the same incremental cash flows calculated earlier and
must yield the same incremental economic conclusions described in
cases A and B but this approach avoids the possibility of incorrectly
handling the incremental tax issues.
E) Uniform Annual Equivalent Revenue Required (UAERR)
528
1.626
.6575
- .4)]
7.95/[t10
+
20(P/A
+
10(P/F1S,3)X1
=
15,2)
=7.9511(49.095X1 - .4)l = $0.22 per unit
G) Some companies view lease versus purchase investment decisions as finance decisions concerning whether to borrow money to
purchase instead of leasing rather than as economic decisions.
Therefore, the after-tax cost of borrowed money rather than opportunity cost of capital is used as the minimum discount rate. lf this
finance decision viewpoint is taken, it is very important to understand
that the investor implicitly is assuming that a unique line of credit
exists to borrow money to purchase assets instead of leasing and
that this borrowing to purchase will have no effect on capital investment budget dollars now or in the future. ln other words, borrowing
today to purchase instead of lease will not affect budget dollars available to invest elsewhere at the opportunity cost of capital. Whether
/ou agree or disagree with the validity of that assumption, implicitly
lhat is the assumption being made. lf the after-tax cost of borrowed
Toney is used as the minimum discount rate, it assumes that you
:an borrow to purchase an asset instead of leasing, but you could
rot borrow that money to invest in other general investments.
10.3 Sunk
529
As discussed earlier in section 9.4 sunk costs are not relevant to analyses
since such costs occurred in the past and cannct be altered by present or
future action. The concept that past costs are not relevant to investment
evaluation studies is calied the "sunk cost" concept. If you bu1' eqLripment
for 53000 and use it two or three weeks before deciding that you do not like
it and rvant to sell it you may find that $2000 is the best used equipment
sales price that you can get. The $1000loss is a sunk cost that resulted from
a poor past decision that cannot be altered by present or future action. Economic decisions related to future action should not be permitted to be
affected by sunk costs except for the remaining values and tax effects from
the sunk costs, which are opportunity cost considerations. Examples 10-3
and 10-4 illustrate these considerations, but the following paragraphs present discussion related to the concepts.
Two considerations often confusing to replacement analysts are (1)
proper handling of sunk costs, and (2) proper handling of oppocunity costs
(trade-in or secondhand sale values). Correct handling of these items is necessary for correct replacement analysis. Sunk costs must not be considered
in evaluating expected future costs of one alternative versus another. On'[y
sale value and tax considerations that remain to be realized from sunk costs
should have an eftect on economic analyses involving sunk costs. This
means that actual value should be used in econornic analyses rather than
book value whenever actual values can be obtained. Also, actual tax considerations such as tax depreciation should always be used. If a machine originally costing $5,000 has been depreciated to a book r.alue of $3,000 and has
a current salvage value of $2,000 replacement analysis of this machine must
be based on the current value of $2,000 because the difterence of $1,000
between book value of $3,000 and actual value of $2,000 is a sunk cost that
future action will not retrieve. However, depreciation for the analysis should
be based on the $3,000 book value. A tax write-off benefit is the only potential value of a sunk cost other than salvage value. The owner has the choice
of keeping the machine or holding $2,000 cash plus the potenrial rax writeoff benefit, not $3,000 cash equal to book value.
Trade-in value involves two sources of confusion. These occur primarily
because it is possible to make valid replacement analysis either working
with costs and revenues handled from the accounting "receipts and disbursements" viewpoint or liom the actual value viewpoint. It will be discussed and illustrated that either approach is valid as long as they are not
mixed for different assets. First, from the accounting viewpoint, since no
530
531
Solution:
When sunk costs and trade-in values are involved in economic
analyses, as they usually are in replacement analyses, there are
three different, equivalent, equally valid ways of handling the year 0
dollar values for correct economic analysis results. These three ways
will be called Cases 1, 2 and 3.
Actual Value Viewpoints
CASE
Accounting Viewpoint
CASE 2
CASE 3
C=0
532
The $7,000 cost of the old asset 2 years ago is a sunk cost that
does not affect the analysis except for the tax effects of remaining
tax book value of $a,900 yet to be deducted by depreciation. The
$560 year 0 tax saving if the old asset is sold results because the
sale value is proposed to be $1,400 less than the remaining tax book
value ($g,SOO sale value - $4,900 book value). This $1,400 loss
would be written off against other income saving $560 in tax for the
stated 40"/" etfeclive income tax rate.
ln Case 1, which represents "actual values", the $3,500 sale value
and $560 tax savings from the write-off if the old asset is sold are
treated as opportunity costs incurred by the owner if the old asset is
kept instead of being sold. lf the owner passes up the opportunity to
sell the old asset in order to keep and use it he forgoes receiving the
$4,060 cumulative sale and tax benefits, so this is a real cost, commonly called an "opportunity cost" for keeping and using the old
equipment.
s33
Case
Year
0123
Flevenue
-Op. Costs
-Depreciation
Taxable lncome
-Tax@
4O"h
Net lncome
+Depreciation
-Capital Costs
-4.1
Cash Flow
-4.1
-4.6
1.8
1.
0.7561
(PIF1s"/",2\
0.5718
0.6575
+ 1 .6(P/F1 S./",g) + 2.1(PlF 15"/o,4) = 8.45
PW Cost, Case 2 = 7.85, PW Cost, Case 3 = 4.35
Case
Year
Revenue
-Op. Costs
-Depreciation
Taxable lncome
-Tax @ 40"/"
Net lncome
+Depreciation
-Capital Costs
Cash Flow
00
0123
-1.0
-1.3
-1.1
-2.2
-1.2 -1.3 t
-1.6
-3.9
-3.1
3.9
0'8
" The book value write-off and year 4 depreciations are combined.
534
0.8696
0.7561
PW Cost, Case 1 = 9.0 + 0.1(P/F1 5o/ol) 0.2(PlFllo/o,2)
0.6575
+ 0.1(P/F1S%,g)
0.5787
0.8000
0.6400
PW Cost6gp, Case 1 = 4.1 + 1.2(PlF2S"/",i + 1.4(P|F2S"/",21
0.4096
0.5120
= 7 .63
0.8000
0.6400
PW Costpgyy, Case 1= 9.0 + A.1(PlF2S"/",i -'0.2(P|F2S"/",2)
0.5120
+ 0.1(P|F2S"/"3)
0.4096
0.8(PlF25"/",4) = 8.67
Notice now that the present worth cost advantage of the old equipment compared to the new has spread from $90 to $1,040.
Service
Wlrcn dffirent service producing altenmtives are projected to give drffrrertt senice per da1,, week or vear (or other periods), it is necessary to get
lhe altenrutives on a common service-producing basis per period (as well
l)
2)
t-erent service.
-&
s36
75
"2"
Accounting Viewpoint
CASE 2
CASE 3
C=1 95
C=0
Book Value =
75
Book Value = 75
sold C=240+48-195=93
NEW 0 Book Value = 240 0 Book Value = 240 0 Book Value = 240
C=240
C=240+48 tax if
The $48 tax if the 3 old assets are sold is based on taxing the
$120 capital gain ($tgS sale value - $ZS book value) as ordinary
537
Year (Case1)O
Revenue
Costs
-Depreciation
-Op.
Taxable
-Tax @
lncome
4O/"
Net lncome
+Depreciation
Flow
-147
-90 -105
-37.5 -37.5
-120
-135
-127.5 -142.5
51
57
-120
18
-135
-76.5 -85.5
37.5 37.5
-72
-81
-39
-72
-81
-48
0.8696
54
0.7561
Case 1 PW CostgLD = 1!7 + 39(P1F1 S"/",i + 48(PiFi 5%.2)
0.6575
0.5718
+ 72(PlF1S"/oS) + 81(P/F1 S"/o,4) = $310.8
Case 2 PW CostgLD = Case 1 PW Costglp + 48 = $358.8
Case 3 PW CostgLD = Case 1 PW
Cosiglp
147 = $163.8
Year (Casel)0
Revenue
60
-Op. Costs
-Depreciation
-50
-34
Taxable lncome
-Tax @ 40'/"
-84
34
Net lncome
+Depreciation
-60
59
-70
-42
-80
-105
9
48
-112
45
-125
-50
34
-71
59
47
42
105
-16
-12
-25
30
-11
50
-75
538
0.7561
0.8696
Case 1 PW Costpglry =240 + 16(P/F15y.,1) + 12(PlF6y",2)
0.5718
0.6575
+ 25(PlF1S"/o3)
- 147 = $115.3
Providing the service with the NEW machines has a $48,500 present worth cost advantage for all cases, so select NEW. Notice that if
you compared 1.5 old assets to 1 new asset, the advantage is similarly
favorable to the new, but by $24,250 (a factor of two difference). Similar resulls occur for comparison of 1 old asset wiih 2/3 of a new asset.
Note that while the accounting approach leads to correct economic decisions, it does not give true eqilivalent annual cost. The
accounting approach should not be used if you want to know what it
actually cosfs to operate equipment in addition to obtaining valid
economic replacement decisions because it combines trade-in
financing with cost economics.
Break-even Cost Per Unit of Service Analysis
Use Case 1 actual value present worth cost results for "3 old
machines" or "2 new machines" alternatives divided by after-tax present worth service units for 6000 hours of service per year. Only the
Case 1 cost analysis results give actual after-tax cost of service. The
Case 2 and 3 results are only useful for comparing relative differences between the alternatives.
"Old" Break-even Cost Per Hour
2.855
310.8/[(6.0XP/A1S,4X1
=
539
shown in the solution. The Case 1 situation does not exist for
exchange economics of the "Old" assets becaUse there is no tax to
be paid from selling the "Olcl". The Case 2 and Case 3 analysis of
the "Old" assets is the Same for exchange as in separate Sale, Separate purchase in ExamPle 10-4.
Solution:
CASE 2 (ActualValue Viewpoint) CASE 3 (Accounting Viewpoint)
OLD
0 Book Value = 75
C=0
0 Bock Value = 75
(2"
C=24O
C=24(j_^195=45
C=1 95
The *oLD" present worth costs for cases 2 and 3 are identical to
Cases 2 and 3 present worth cost "OLD" for Example 10-4. The
"NEW" cash flows for cases 2 and 3 are based on depreciating the
initial new cost reduced by trade-in gain from "OLD".
Exchange of assets makes the "NEW" assets relatively more
.OLD" in comparison with separate sale/Separate
desirable than the
purchase. This is because exchanging eliminates immediate tax on
gain from sale of the "OLD" which increases the opportunity cost of
ieeping the "OLD" asset rather than disposing of it by an exchange
for "NEW".
540
"Exchange" Analysis of
60
-50
-60
-Depreciation
-r^.,^r-t^ t-^^-- Taxable lncome
-Tax @ 40"/"
-17
_2g
-70
_21
_52
-67
40
-91
36
-72
Net lncome
+Depreciation
-89
36
-55
43
21
52
-34
27
17
-23
-53
29
-24
0.8696
-80
29
0.7561
24(p
iF tiit",Z)
0.6575
0.5718
115/",g) - 9(PlF15"yo,+) = $2gS.+
Case 3 PWCostSgW = Case 2 pWCostryEW 19s
- $100.4
-
+ 34(PlF
541
is
expected that the process will not be needed after three years. A major
reoair costing $3,000 at the end of year two would extend the life alternative "A" through year three with a third year operating cost of $2,500
and the salvage equal to $1,000 at the end of year three instead of year
two. The salvage of alternative "B" is estimated to be $3,000 at the end
of year three and the salvage of alternative "C" is estimated to be
S7,000 at the end of year three. For a rnin;mum DCFROR of 15"/",
which alternative is economically best? Use atter{ax equivalent annual
cost analysis. Assume MACRS depreciation for a seven year life fcr all
alternatives starting in year 0 with the half-year con,vention. Remaining
book value is deducted against other income at the end of the evaluation lives. Assume sufficient income exists against which lo use all
deductions in the year incurred. The effective tax rate is 40%. Assume
the $3,000 major repair at the end of year two for alternative "A" is
expensed at the end of year two as an operating cost. Compare the
alternatives for a three year evaluation life.
A)
C=$6,000
OC=$1,500 OC-$2,000
L=91,000
2
r
fl
B)
I
1
c\
012345
&
C=$10,000 OC=$1,000
6.1
0123
ooo
542
Year
1,000
Revenue
-Op. Costs
-1 ,050 -2,624
6,050
2.420
4,124
1,650
40"/" 343 1,188
Net lncome -514 -1,782 -3,630 -2,474
+Depreciation 857
Flow
-2,580
0.8696
0.7s61
0.6575 0.43798
$3,408
Revenue
-Op. Costs
571
-857
+Depreciation 1,429
1,380 1,260
1,269
2,449 1,749
4,373
ACg
0.8696
0.7561
380(P/F1 S,1 ) + 140(P/F 6,2)
- {9,429 -
543
0.6575 0.43798
2,469(P lF1 5,3))(tuP1 5,0) = $3,320
7,000
-500 -600
-700
-3,929
-3,049
178
-1,200 -2,357
-1,829
147
-Op. Costs
4A"/"
Net
lncome
0.8696
AC6 = [13,200
0.7561
620(P/F1 5,2)
0.6575 0.43798
6,229(P lF1 5,3)l(A/P 1 5,3)
= $3,374
Select Case "8" with the smallest equivalent annual cost although
results are effectively break-even.
10.6 Optimum Replacement Life for Equipment
It frequently is necessary to replace equipment, vehicles, piping systems
and other assets on a periodic basis. Determination of the optimum replacement life for these replacement situations is a very important type of evaluation problem. In general, it can be shown to be economically desirable to
replace assets when the after-tax operating, maintenance and repair costs for
544
the old assets are greater than the equivalent annual cost projected for the
new assets. However, in ml.lrY real situatioxs the analysis becomes more
complicated because new assets often have different productivity than old
assets, requiring the prorating of costs in some manner to get all the alternatives on the basis of providing the same produetivity or service. Also, if
existing assets have a positive fair market value the incremental opportunity
cost of using existing assets one more period must be accounted for in addition to operating type costs in a correct optimum replacement study. In
other words, optimum replacement time calculations are dynamic by nature.
Using yearly evaluation periods, every year you must estimate: (1) the second hand market value of existing.assets (which determines the opportunity
cost related to keeping the asset another year), (2) salvage a yeff later for
the existing assets, (3i operating, maintenance and repair costs to operate
the existing asset one more year, and (4) any major repair or rebuild costs to
operate one more year. Using these values, calculate the annual cost of
operating one more year with the existing asset. Compare the existing asset
annual cost for one more year of operation. with the equivalent annual cost
of operating with a new (replacement) asset for the expected optimum usetul life of the new asset. Replace when the after-tax annual cost of operating
one more year with existing assets is projected to be greater than the equivalent cost of a new alternative for its optimum expected life. This criteria
assumes that the annual cost of operating with existing assets will get bigger
in future years due to asset age and obsolescence.
545
PROBLEMS
10- 1
I
x
s
+
A machine produces 1000 units of product per day in an existing manufacturing operation. The machine has become obsolete due to tightenerl product ciuality standards. Tr.r'o itew replacemenl nrachines are
being evaluatecl from an economic viervpoint. Replacement macirine
'4" will cosr $ 15,000 and will produce the ne eded 1000 urits of product per day for the next 3 years with annual escalated doiliu operating
costs projected to be $6,000 in year 1, $7.000 in year 2 and $8,000 in
salvage value at the end of year
,vc-zlr 3 with a 52,000 esr:alated dollar
3. Replacement machine "8" will cost $21,000 and can produce up to
1500 units of product per day for the next 3 years with annual escaIated dollar operating costs of $5,000 in each of years 1, 2 and 3 for
either 1000 or 1500 units per day, with a $3,000 escalated dollar salvage value at the end of year 3. Depreciate both machiles using 5 year
life Modit-red ACRS depreciation starting in year 0 with the halt'-year
convention. Assume that other taxable income exists that will permit
using all tax deductions in the year incurred. For an effective income
tax rate of 40Vo, use present worth cost analysis and break-even cost
per unit oi serlice analysis, assuming 250 working days per year, for a
rninimum escaiated dollar DCFROR of ZAVo to determine if machine
'4" or "B" is economically best assuming:
Al no use exists
machiire
"B"
can procluce,
B) another division of the company can utilize the extra 500 units of
product capacity per day of machine "B" and that division will
pick up one third of machine "B" capital cost, operating costs,
depreciation, salvage value and related tax effects.
10-2 An existing macitine 'A" has a $2,000 sale value at year 0 and an estimated 2 more years of useful life with end-of-year operating costs of
546
vide the same service as the original replacement machine 'A" and
could be operated for an annual cost of $1,500 in year I escalating
$500 per year in following years. Machine "B" is estimated to have a
salvage value of $3,000 5 years from now. Use present worth cost
analysis to compare these alternatives for a 5 year evaluation life and a
minimum DCFROR of 15Vo for the following siruations.
A)
depreciation stafting in the year the costs are incurred with the
half year convention. Other income exists against which to use
deductions in the years incurred and the effective income tax rate
is 407o.
the capability of giving 407o more p,roductivity than machine 'A" over each of the 5 years and we'
assume the additional productivity can be utilized, compare the
economics of machines 'A" and "8" if operating costs will be the
same as in part 'A' for both machines.
l0-3 A 4 year old machine has a remaining book value of $21,000 and a
second-hand salvage value of $30,000. You need to analyze the cost of
keeping this asset to lease to another party for the next 3 years. A
major repair of $25,000 at year 0 that can be expensed for tax deduction purposes will extend the life of the old asset another 3 years.
Operating costs in years 1,2 and 3 are projected to be $15,000,
$18,000 and $21,000 respectively. The salvage value at year 3 is estimated to be 0. The income tax rate is 40Vo and the minimum escalated
dollar DCFROR is 20Vo. Other income exists against which to use
deductions in any year.
A)
cost of operating with the old machine for years 1,2 and 3.
Assume that the remaining book value of $21,000 will be
deducted as depreciation ar year 0 if the asset is kept.
B)
10-.1
A)
All values
c=$32
B)
547
C=Sl5 oc=$20
OC=$21
-1
OC=$3
OC=$4
OC=$24 L=$3
C=$,sO
oc=$16
The time diagrams show the capitai costs (c), operating costs (oC)
and salvage values (L) for two alternatives under consideration for
providing needed processing operation service for the next 5 vears.
Alternative "A" involves acquisition of nerv equipment norv r.r.ith
annual labor intensive operating costs and salvage values as shorvn.
Alternative "8" invol'es buying used equipment now and replacing it
with new labor saving equipment currently in the der,e|6pn,"nt stage,
but expected to be available for installation in two stages at years.l
and 2 for costs and salvage values as shown. A1l new and used capital
costs are to be depreciated using 7 year life modified ACRS depreciation sterting in the years costs are incurred with the half-year convention, rvith the exception that the years I and 2 alternative ..B', replacemeut costs go into service at .l'ear 2, so start depreciating the total
$82.000 cosr ar vear 2. Take u'rite-olts on the remaining book values
in the 1'ear assets lre rcplaced or sold. Assume other income exists
against which ro use dcductions rn the year incurred. The effective
income tax rate is 40oh. For a rninimum DCFROR of l5zo use
DCFROR Analysis to derermine the economically better alternative.
i
DCFROR is l5%. Use a 5 year evaluation life. The new dozer pur-
zero book value with an estimated zero salvage value in 5 years. The
new dozer would be depreciated starting in time 0 with the half year
convention using 7 year life Modified ACRS depreciation. The effective income tax rate is 40vc and other income exists against which to
use all deductions in the year incurred. Assume overhaul costs as well
as operating costs given in the following table will be expensed in the
year incu*ed. Assume the new doz-ei will givb'l3}vo o1*,c service
productivity given by the old and that: a) the exrra service cannot be
utilized, b) the extra service can be utilized. For break-even cost per
unit of service analysis assume 2,000 units of service per year with the
old and 2,600 units of service per year with the new.
Non-Operator
Cost per Operating
Year
Old
0
1
2
3
4
5
10-6
,ro
28.0
31.0
35.0
39.0
Hr.
New
t*
22.0
24.0
27.0
31.0
3s.0
Operating Hrs.
Overhaul Costs
($)
Both
Old
+ooo
100,000
50,000
125,000
4000
4000
4000
4000
New
12sp00
60,000
150,OOO
150,000
A)
Use present worth cost analysis and verify the results with incremental DCFROR analysis to determine if leasing or purchasing is
economically better for a minimum DCFROR of l5Zo.
549
c)
550
Determine
551
Surnmary of Data:
Cost
5454,328
Sales Tax $ 32,251
0
Y-ear
Insurance
I-ares, Perrnits
llajor Rcpairs
Ntinor Repairs
Salvage
"r{ours/Year
Alt. HoursiYear
10-10
2.498
10.,150
15,000
2,619
6.815
2,808
5,679
100,000 75,000
1s,900 16,954
2,976
3,155
4,5.13
3,4!.:7
125,0r-)0
17,865 38,937
136,298
4.000
3.000
4,000
3,000
3,000
3,000
2,000
3,000
2,000
3,000
10-li capital
Capital
OC=$100
L=$300
Less Capital
Intensive
"B"
OC=$275
L=$0
I
I
CIIAPTER
11
11.1
554
your $10,000 initial equity investment over the period of rime involved. The
effect of 507o borrowed money or leverage has enabled us to double the
profit we would receive per equity dollar invested. At this point it is appropriate and relevant to state a basic law of economics which is:.,,There ain,t
no free lunch." You are not getting something for nothing with borrowed
money. Leverage can work against you in exactly the same manner that it
works for you. To illustrate this, consider that the shares of xyz stock drop
in price to $5 per share from their initial $10 per share. If we paid cash for
1,000 shares, this is a $5,000 loss or a-5ovo return on our $10,000 equity
investment. If we had used $10,000 borrowed money together with our
$10,000 equity, we would have lost $5 per share on 2,000 shares or
$10,000. This means we would have lost alr of our equity because the
$10,000 income from selling 2,000 shares at $5 per share would be needed
in its entirety to repay the $10,000 borrowed money and we would have a _
1007o return on our equity investment. Note that leverage can and will rvork
against us as well as for us in different situations.
we now want to demonstrate the handling of borrowed money in
DCFROR and NPV analysis of various types of projects. As with the xyZ
stock illustration just discussed, including leverage in analyses means we
are calculating the rate of return or NPV based on our equity investment in a
project rather than on the total investment value. A1l of the examples and
problems presented in the text to this point have been for cash investment
situations. There are three basic dffirences between the analysis of cash
i nv e s t nte nt a Lt e rnat iv e s and inv e s tment alt e rnat iv
e s inv o lv in g b o rrow e d
nlotl.e)). First, interest on borrowed monet- is an additional operating
expense tax deduction that must be accounted for each evaluation period
thut mortgage payments are nnde. second, loan principal payments are
additional non-tax deductible capital costs that must be accounted
for as
after-tax outflows of money each evaluation period that mortgage pq-ments
are made. Third, investruent capital costs mttst be adjusted for borrowed
ntone)' inflows of mone,v each evaluation period that loans are made. These
three adjustments are the basic evaluation considerations that rnust be
accounted for in leveraged investment analyses that are not present in cash
"
investment analyses.
Chacter
11
555
The $900 loan is repaid with a single ),ear three payment (often called
a balloon payment). This approach is seldom used with personal or
itmmercial loans but is the basis for U.S. "E" Bond and U.S. Treasury
Zero Coupon Bond (deep discount bond) navments:
i.oan = $900
Balloon Payment
- $900tF/P1g7,3)
= $1,198
The year three repayment of the loan principal is $900 while the
acerued interest equals $298.
The $900 loan is repaid with annual pavments of the interest due but
no annual loan principal payments, so loan principal is paid in the full
anount at year three. This is analogous to conventional U.S. Treasurv
Bond and Corporate Bond payments.
Loan = $900 Principal =
@ 107, Int.."rt Int".".t
$0
$0
$900
0
3. The $900 loan is repaid with annual payments inclr.rding the interest
ciue plus uniform equal loan principal pa),ments each vear that leave
loan principal orved at the end of year three equal to zero. This loiin
rlr()rtgage payn)ent approach tnakes it very easy to determine loan
Crincipal and interest paiti each ycar.
Lcan = $;900 Pnncipal = $300 $300
@ l07c Interest Interest = $90 $60
$300
$30
4. The $900 loan is repaid with uniform equal annual mortgage payments {900(A/P17V"J) = $361.90 / year}. This is one of the most
c:onlnlon types of mortgage payments for both personal and corporate
loans.
Payment =
Principal
$900
Loan =
Interest
@ l07o Interest Balance
556
These four approaches to amortizing a three year $900 loan have been
related to a fixed annual interest rate of LTvo per year that did not vary
over
the loan life. variable interest roans (or aa3uitaute rate mortgages or
ARM's) have the loan interest adjusted periodically, such as every six
months, by keying the loan interest rate on either three month, six month
or
twelve month rreasury Bills, three year Treasury Bond rates, or some other
index of interest rates plus some fixed percentage or other measure to calculate the loan interest rate. Any one of the four approaches presented here
along with flat or add-on interest rate loans can be idapted tovariable inter-
In Example 11-1 you will see how leveraging a project with borrowed
money makes project economics look much better on a leveraged basis than
on a cash equity investment basis. However, do not compire leveraged
investntent economic resuhs with cash equity investment eionomic results.
since leverage improves prgject economic results when borrowed money
intercst is less than the boruowed money eants in the project, you must look
at all project economics with a common amount of leveragefor economic
results to be comparable for dffirent investment projects. Most companies
make zero leverage, which is the cash equity analysis situation, the common
leverage used for all income and service-producing discounted cash flow
economic analyses.
EXAMPLE 11-1 Analysis of a Leveraged lnvestment
An investment project requires the year 0 investment of gj00,O0O
for depreciable assets and $15,000 for working capital. The depreciable assets will be depreciated straight line foi a 5 year life staiting
in year 0 with the half year convention. Annuar project income is
expected to be $65,000 with annual operating cosis of g25,000,
assuming a washout of escalation of annual income and operating
costs. Year 4 asset salvage value and working capital return are estimated to be $35,000. The effective tax rate is 40"/o and other income
exists against which to use tax deductions in any year.
A) calculate project DCFROR assuming cash investments (1oo%
Equity).
i,
g and 4.
557
END
OF
YEAR YEAR
1 $100.000
$31.547
2
7E.453
31.547
3
54.751
31.547
4
28.679
_ rL!32_
$126.188
TOIALS
PRINCIPAL
PR|NCIPAL
C'IVED
$10.0000
7.8453
$21.517
23.7A2
54.751
5.4751
26.O72
28.679
2.8679
28.679
526.1883
$100.000
$78.453
C:1ll___
l=100
lnt= 2.87
P=28.68
L=35
558
l=65 l=65
oc=25 oc=25
c=15
l=65
l=65
OC=25
OC=25
lnt=10.00 lnt= 7.85 lnt= 5.48 lnl= 2.87
P=21.55 P=23.70 P=26.07 P=28.68
L=35
Year
Revenue
-Op. Costs
-Depreciation -10
-Write-off
Taxable lncome -10
4
-Tax @ 40"/"
Net lncome
-6
+Depreciation
10
+Write-off
-Capital Costs -115
Cash
Flow -1'1i
65
-25
-20
65
65
100
-25
-20
-25
-20
-25
-20
-25
20
20
20
30
-8
-8
-8
-12
12
12
12
20
20
20
18
20
25
32
32
92
63
100.00
-10.00
-7.85
-5.48
-25.00
-20.00
-25.00
-2.87
-10.00
10.00
12.15
14.52
4.00
27.13
-4.00
-4.86
-5.81
Net lncome
-5.00
+Depreciation
10.00
+Wriie-off
-.Principal
-Capiial Costs -115.00
+Borrowed
100.00
-10.8s
6.00
20.00
t,4Y
20.00
8.71
20.00
16.28
20 00
2s.00
-21.55
-23.70
-26.07
-28.68
-Depreciation -10.00
-\Yrite-off
-lnterest
Taxabie lncome
-Tax @.10%
cash
Flow
PW Eq: 0 =
i=
2.64
-11
32.60
-11.00 + 4.45(p/Fi,1) + 3.59(p/Fi,2) *2.64(?/Fi,g)
+ 32.GA(plFi,4)
I
T
't
C'arler'
11
561
of revenue
at the 4clk lax rate by $4,000 each year. The net effect
each
by
flow
$6,000
and tax changes will increase or decrease cash
the
Making
yea. for eithei the cash investment or leverage analysis.
$eC00peryarcashflowadjustmentisaneasywayofobtaining
results'
the sensrtivity analysis cash flows that lead to the DCFROR
Cash tnvestment Sensitivity
Base Case Cash
Analysi=
32 32 32
Flowslll
63
oCFRoR
i4.2%
0
$1C,00C Revenue
-111
$1C.C00 Revenue
-111
38
38
38
69
21.4%
26
26
26
57
7.2%
1 2 3
De,.:rsaseFerYear 0
or
The changes in cash investment DCFROR due to increasing
changes
t50%
to
decreasing revenue by $10,000 each year amount
4
012
$10,000 Revenue
lncrease Per Year
g10,000
.0
Revenue l!0
Decrease
'
-11
PerYear
DCFROR
32.60
53.7t/.
38.60
101.0%
26.60
12.4"/"
10.45
9.59
12
-1.5s -2.41
8.64
34
-3.36
562
"8" Leveraged
CF
-11.00
+4.45
+3.59 +2.64
+32.60
* After-tax interest equals before-tax interest multiplied by the quantity one minus the tax rate.
Once either leveraged or cash investment project cash flow has
been obtained, adjusting for loan dollars, after-tax interest and loan
principal with the proper signs quickly and easily gives the other
cash flow.
11.1a Joint Venture Analysis Considerations
If an investor does not have equity capital for development of an investment, an alternative to borrowing is to bring in a venture partner. The
advantage to a venture partner arrangement versus borrowing is that , if the
project goes bad, a venture partner does not have to be repaid, but in most
situations, a bank loan must be paid whether a project succeeds or not. A
disadvantage to joint ventures compared to borrowing is that you generally
have to give up more profits to entice a venture partner than is required to
cover payment of borrowed money interest and principal. However, even
when an investor has the money to fully fund a new project, sharing the project with a joint venture partner enables the investor to spread investment
risk over a larger number of investments. In some investor situations this
may be perceived to be desirable.
Chailier
1.1
563
11-l'
a 5U-50
9.75 9.75
-3.25 -9.25
-1.30 -2.61 -2.61
Taxable lncome
-Tax @ 40%
Net lncome
+ Depreciation
+ Write-otfs
- Capital Cost
Cash
Flow
-1.30
3.89
3.89
0.52
-1.56
-1.56
-0.78
2.33
1.30
2.61
2.33
2.61
3
9.75
4
15.00
-3.25
-2.61
-3.25
-2.61
-3.26
3.89
-1 56
5.88
-2.35
2.33
3.53
2.61
2.61
3.26
-15.00
-14.48
DCFROR = 21.5"/"
NpV@12.0%=93.37
-v
4.94
4.94
4.94
9.40
55.25
-21.75
-8.70 -17.40
Taxable lncome
- Tax @
55.25
-21.75
-17.40
16.10
16.10
3.48
4.44
4.44
-5.22
+ Depreciation 8.70
+ Write-offs
- Capital Cost -100.00
9.66
17.40
9.66
17.40
40%
Net lncome
Cash Flow
-870
55.25
-21.75
-17.40
85.00
-21.75
-17.40
-21.70
16.10
-6.44
9.66
17.40
24.15
-9.66
14.49
17.40
21.70
53.59
DCFROR = 13.1"/"
NPV@ 12.O/"=$2.53
lf the project is considered to be relatively risk free with upside rev-
enue potential above the revenues built into this analysis, a venture
partner might accept this venture split. Otheruvise, the original owner
may need to sweeten the pot by increasing the venture revenue fraction above 85.0% or by reducing the venture partner..cost fraction
below 87.0%. Joint ventures of this type usually involve some negotiation to satisfy the needs of the venture partners.
EXAMPLE 11-2 A Land lnvestment Analysis With Leverage
Assume you have a chance to buy 20 acres of land for 911,000
with a $1,000 down-payment and annua.l end-of-year mortgage payments of $2,000 principal plus 107o interest on the unpaid principal.
Assume further that you think the land can be sold for 916,000 cash
three years from now and that the loan would be paid off at the time
of the sale. The effective income tax rate is 30%. Calculate the
DCFROR based upon:
.!'
{
fr
Cl,,rpter
11
565
P=
principal
i=$1,000
C=
$_1__,Q
01
I ___g=$?, opq
i= $800
p=$2,000
i= $600
p=$6,000 L=$16,000
cash Flow =
PW Eq: 0
-$6,420+14,500
Net = 98,080
After-Tax Diagram
Cash Flow
_911 000
$14,500
PW Eq: 0
= -$11,000 + $14,500(P/F;,3)
i = Cash lnvestment DCFROR =9.6/"
566
&
*
.*
For the leveraged case yearly interest and principal costs are the
same, while the new after-tax salvage is 914,000-$9,000(.g0) tax or
$13,100.
*r
Leveraged lnvestment
tl
PW Eq: 0 =
-1
Cash lnvestment
PW Eq: 0 = -$'t1 ,000 + 913,100(P/F;,3)
The new cash investment DCFROR is 6.0%
Percent variation from base case result (9.6 - 6.0)/9.6 x 100 = 37"/o
D) Break-even Analysis
To achieve a 25o/o leveraged DCFROR on equity invested dollars,
iet "X" equal the break-even required after-iax cash flow.
2,200(PlFi,1 )
2,560(plFi,2) + X(plF1.3)
Sclving for "X" gives X = $g,372 for i* = 2't%. What before-tax sale
value will give this cash flow? Let "y" equal the break-even beforerax gale value.
'/
lr
I
t
t?
{
':',
- (Y-11 ,000X.30
tax rate)
Anal.vsi.s
\\/e lra'e seen in Exanrples ll-l and 11-2that both the meaning of econonric analysis results and the risk and uncertainty associated with leveraged and cash investment project economic analysis results are very different. This brings up the question concerning, "how should leveraged
investments be evaluated for investment decision making purposes?,, To
reach a conclusion concerning the best answer to that question, consider the
fbllor,ving comments:
I)
568
2) Since more and more leverage gives higher and higher DCFROR
results, the use of leveraged economic analysis results for decision making
purposes can sometimes mislead the decision-maker into thinkinij a
marginal project is a better project than it actually is. For this reason there is
considerable merit in making zero leverage, the cash investment case as the
common basis for comparing all investment opportunities. This approach is
based on analyzing all projects from the viewpoint, "would I be willing to
invest my cash in any or all of the projects considered if I had the money?"
If the answer is yes, "which projects would be best?" The cash investment
analysis approach is used by a majority of companies. Another advantage of
this approach is that it does not require knowing the financing conditions
when the analysis is made. Since financing arrangements often are not finalized until just before initiation of a project, using cash investment economic
analysis eliminates the need to guess and make sensitivity analysis for different borrowed money assumptions. Remember, if the after-tax cost of borrowed money is less than the cash investment DCFROR, leverage will work
for you and the leveraged DCFROR on your equity investment will be
greater than the cash investment DCFROR for any and all investment projects. If the cash investment economic analysis results look satisfactory, the
leveraged results will look even better if the after-tax borrowed money interest rate is less than the cash investment DCFROR.
3) There are exceptions to every rule. In cases where interest free nonrecourse loans are made available by another company to be repaid out of
production product, or revenue if a project is successful, the leverage considerations are not the same as we have been discussing. To illustrate this
concept, in past years some companies needing natural gas reserves have
tunded drilling companies in this manner. If the obligation to repay the loan
does not exist if the project fails, the risk and uncertainty conditions obviously are very different than when repayment of the loan must be made
whether we succeed or fail. In the non-recourse loan a.nalysis case we
would want to verify that the net present value that we could get by tying up
our equipment and men in the leveraged interest free loan project would be'
at least as great as the net present value we could generate by putting our
men and equipment on other projects being considered. Comparing
DCFROR results is of little or no value in this case because you get an infinite percent DCFROR with 1007o borrowed money.
4) Different projects attract better financing than others because of relative
risks and uncertainties involved with different projects in the eyes of the
569
lender. Cash investment analysis does not take this consideration into account.
Looking at projects on a cash investment basis is going to give you a good
and probabiy the besr basis for er.aluatins how a lender will view the econr-rmic potential and risk and uncenainty associated with projects, but it may
i-'c nccessary to niake a ieveracei anal'sis comparison to take into account
tinancing ditferences. Remember. the rrumber one concern of a lender is,
''\\'ill there be sufficient project cash flow to cover the mortgage payments
over the lit'e of the project?" usually a banker llkes to see at least a 2 to I ratio
ot'cash flow to debt mortgage payments each year, but obyiously this ratio,
which is sometimes called the "debt service ratio," vauies widely with the
risks and uncertainties that are felt ro exist with regard to project cash flow.
11.3 Current
Under the 1986 tax retbrm law, individual and corporate taxpayers in
20c0 continue to be a;le to deduct interest on business debts incurred for
the purpose of generating inrestment or business income. However, that
same tax biil put significant restrictions on the kind of income that individuals can use interest deductions a-eainst and limits or eliniinates the
deductibility of certain interest by individuals. Two major Jauors in the
tax latv for non-business taxpaygrs are: (l) interest on personal loans is
non-deductible except for home ntortgage loans on principal and second
honrcs to the extent the debt does not exceed the purcha.se price plus
intprovenrcnts, which is the same restriction that applies to trade or busi-
570
ness loans, (2) new limitations apply to the deduction of investment interest,
limiting this deduction to the amountof net investment income,for the year :,
Interest on personal loans such as car loans and unpaid credit card balof non-deductible interest, referred to
as "personal interest." includes all interest other than:
ances is not deductible. This category
1)
2)
3)
4) Certain
interest.
;
r*
t
$
s71
accountant is
money.
boffowed
tvisable before making new investments involving
2lnterest
Year
Year 2
Ner,v
aD
$23,845 = $356,155
= $356,155(.10) = $35,615
$26,230 = $329,925
572
-lnterest
-Depreciation
-Write-offs
-Loss Forward
Taxable lncome
Tax @ 31"/o
70,000
675,000"
-75,000
-39,000
-12,545
-75,000
-35,615
-13,091**
-374,364
-55,545
-55,545
'Net
lncome
+Depreciation
+Write-off
+Loss Fonnrard
-Loan Principal
ital Costs
121 ,395
-37,629
380,000
-55,545
83,756
'12,545
13,091
-23,845
374,364
55,545
-356,155
-400,000
sale value.
573
trse o'er DCFROR analysis since NPV results, for a given minimum
DCi-Roi(. vary over a finite range as you go from zero to l\ovo borrowed
oronev instead of the infrnite range over which DCFROR results vary. Howerer. .tbr leveraged NPV results to be valid .for decision-making purposes,
It has been emphasized throughout this text that the opportunity cost of
capital, which is the return on investment forgone if a nerv investment is
accepted, is the appropriate "minimum rate of return" or "hurdle rate', to
luse irt economic evaluations. In this section we want to exanrine the effect
of leverage (borrowed money) on opportunity cost of capital. It wilr be
shou'n that opportunity cost of capital is still the appropriate minimum rate
of retum (or discount rate) with leverage as with cash investments, but that
the opportunity cost or discount rate increases as the proportion of borrowed dollars incorporated into the analysis of other opportunities
increases. This assumes that the after-tax cost of borrowed funds is less than
the cash investment DCFROR of the project or projects representing other
investment opportunities so that levt:rage enhances the economic potential
of these other investment opportunities.
To illustrate the effect of leverage on opportunity cost of capital, assume
that the best alternative use of funds, or an investment typical of other cash
574
Year
l_5
Salvage
70,000
Revenue
-Oper. Costs
-20,000
-Write-off
_100,000
50,000
Thxable
Net Income
--Capital
Costs
+Write-off
30,000
0
0
0
-i00,000
+100,000
-100,000 30,000
Cash Flow
PW Eq:0
100,000
100,000
i=
DCFROR=30.07o
-Oper. Costs
-Interest
-Write-off
Thxable
-Tax @ 40Vo
Net Income
+Loan Principal 25.00
-Capital Costs -100.00
+Write-off
Lever. Cash
70
-20
-2.5
-20
-2.09
47.5
47.91
-19.00
Flow -75.00
70
-19.16
70
-20
70
170
_20
-1.64
-20
-t.14
48.36
48.86
49.4
-19.34 -19.s4
-19.76
-0.6
-100.00
29.64
_5.46
-6.00
+100.00
24.40
24.24
24.06 23.86
123.64
575
cash.flot+'s
investment
')ear
Cash Investment
Cash Flow
+Loan
Income
-100.00
30.00
-1.50
25.00
-After-Tax
Interest
130.00
-0.36
-Loan Principal
= -75 + 24.40(PEi,)
+ 24.24(P/Fi,2) + 24.06(PlFi3)
+ 23.86(PlFi.4) + t23.64(P/F1,5)
576
depreciation, amortization or write-offi against a terminal sale or liquidation value. The rational for capitalization of interest is that it is required
under U.S. tax law in certain instances discussed in the next paragraph.
Under special interest capitalization rules, interest on a debt must be capitalized if the debt is incurred or continued to finance the construction. building, installation, manufacture, development, or improvement of real or tangible personal property that is produced by the taxpayer and that has, (l) a
long useful life, which means a depreciable life of l5 years or more under
the 1986 tax reform act, (2) an estimated production period exceeding two
years, or, (3) an estimated production period exceeding one year and a cost
exceeding one rnillion dollars.
577
t.ri."
= $2'151'93
Depreciation Schedule:
Year 3 = ($2,296)(1115)(112)
Year 4 = ($2,296X1i15)
- $ 76.53
= $ 153.06
578
lncome
-Oper Costs
-Post Prod. lnterest
-Depreciation
-Write-off
Taxable lncome
-Tax @ 40"/"
4,450.0
-160.0
-215.2
-1 53.1
-2,066.4
1,855.3
-742.1
1,113.2
76.5 2,219.5
-144.1 -2,151 .g
-56.1
22.4
Net lncome
+DeprecMrite-off
+Loan Principal 600
760
Costs
-Capital
-1,100
-760
Cash Flow
O
-500
PW Eq: 0 = -500
400.0
-150.0
-229.6
-76.5
-33.7
936
*936
-101
.3
,190.9
101.3(P/F1,3) + 1,180.8(p/F1,4)
579
Example
11-5
Lease OC =
Lease
$1750
$1,000
OC = $3,500
OC = $1,000
000
oc = $3,500 oc
oc = $1,500 oc
L = $2,000
= $1,750
= $2,000
L=0
580
-lnterest
-Depreciation
Taxable
-Tax @ 40"/"
Net lncome
+Depreciation
-Capital Cost
+Loan
-'t.00
-1.00
-2.00
-3.20
-1.50
-0.70
-1.92
2.00
--2.00
-0.40
-2.99.
+0.80
-5.20
4.12
+2.08
+1.65
-1.20
+2.00
-3.12
-2.47
+3.20
+1.92
+2.88
-3.00
-3.00
-4.00
-2.00
-1
.::
-3.28
.l
';.
rl
r:
+1.31
-1.97
-10.00
+10.00
-Loan
Leveraged
Year
Revenue
Costs
_3.75
Taxable
-Tax @ 40"/o
-1.75 -4.50
+0.70 +1.80
_3.75
+1.50
Net lncome
-1.05
-2.7A
-1.05
-2.70
-Op.
-CapitalCost
Cash Flow
-5.00
+2.00
-2.25
-3.00
-2.25
harler
11
581
.7561
.8696
F15,2)
+
3.00(Fi
+
2.70\PlF
1 .05
1s,l )
.6575
+ 2.25(PlF153) =7.14
'he leveraged purchase present worth cost iS lesS, So Select leverrged purchase over leasing for a 15% leveraged c.liscount rate. This
,icnornic conclusion is opposite the conclusion that was reached in
ixample 10-2A where the analysis was done on a cash equity
t-o 25"/o,
3efore-tax
ncremental
)urchase/Lease
S=1.75
S=3.50
S=3.50
S=1.75 L=2.00
582
1.75
3.50
3.50
-Depreciation
-lnterest
-2.00
-3.20
-1.00
-1.92
-0.70
-2.99*
-0.40
Taxable
-Tax @ 40"/o
-0.25
+0.10
4.70
+0.88
+0.47
+0.28
-0.35
-0.1 9
Net lncome
+Depreciation
-Capital Cost
+Loan
-Loan Principal
-0.'t5
*o.42
+3.20
+0.53
+1.92
+0.28
+2.88
-3.00
-3.00
-4.00
Leveraged
+2.00
-10.00
+10.00
CF
3.75
.8696
0.22(PlF1S,1)
-0.g4
depreciation.
.7561
0.SS(P/F1 S,Z)
.6575
0.84(p/F15,3)
= $0.69
Note that positive leveraged cash flow in year 0 is followed by negative cash flow in years 1,2 and 3. Rate of rejnvestment requirement,
ratherthan rate of return meaning, is associated with the 15% minimum discount rate. lt would be impossible to calculate DCFROR for
this incremental analysis without going to either growth RoR or present worth cost modified RoR analysis to get negative cash flow followed by positive cash flow which is a requirement to calculate rate
of return.
s83
Savings
*Depreciation
Ta.xabie
t@ 40"h
-3.20
-1.00
x/2-2.0 x-4.2
-2.00
Irlet lrrcome
.6x/2-1.2
+Depreciation
-Capital Cost
+Loan
-Loan Principal
-10.00
Leveraged
+2.00
.6x-2.52
+3.20
.6x-1.57
+1.92
.6x/2-.77
+2.88
+10.00
-3.00
CF
-3.00
xl2+2.0
-1.92
-2.88
-0.40
-0.70
x-2.62
x/2-1.28
*.4x+1.68
-.4x/2+.8
-.4x+1.05 -.4x/2+.51
-interest
-Tax
XX
xl2
-4.00
.3x-1.89
.8696
.7541
2.32)(P/F15,1) + (.Gx - 2.OS)(P|F15,2)
.6575
1.89)(P/F1S,3) = 1.4727x- 4.4638, x = 3.03
0= 1.3902x
2.65)(.6944)
4.067, x = 232
2.65)(.8204)
4.9190, x = 3.14
584
In leveraged analyses, the combination of bomorved money ancl tax savings from tax deductions in the early years often causes positive cash flow
to be followed by negative cash flow, giving rate of reinvestment requirement rather than rate of return meaning to the discount rate. proper understanding of this fact is necessary to calculate and interpret break-even
results correctly. People are used to thinking a large discount rate is going to
give the greatest, and therefore the best, break-even revenue from an Npv
type equation. That is not the case when positive cash flow is followed by
negative cash flow due to rate of reinvestment requirement instead of rate of
return meaning for the discount rate as we have seen. In this case the
smaller discount rate gave the best results for the lessor of the property. This
is a very important break-even valuation principle to understand.
ll.7
Summary
leverage, the foilowing point is considered to be pertinent. Do not borrow money when you have a sufficient trea-
PROBLEN{S
11-1 Your corporation is considering the purchase of mountain recreation
land for a cost of $60,000 and you estimate that 5 years from now it
will be possible to sell the land for $150,000. Assume rhat your corporation is in the 40va effective ordinary tax bracket and that profit from
the sale of the land in 5 years will be taxed as ordinary income. Determine your corporation DCFROR on its equity in the investment for:
A)
B)
i
I
I
ChaDter
{
I
1.1
585
investor purchased land 2 years ago for $ I million and the land has
since been zoned for a commercial shopping center development. The
investor has received an offer rrf $7 ntillion cash for the land now at
year 0 and gain would be taxed as an individual long term capital gain.
Assume the individual ordinary in:ome effective tax rzrte is -15%.
l-2 An
All
C
Bldgs.=30 lncome/Yr.=65 70
C EqoiP.=
(Now)
OPCost/Yt
75
L=+O
will
be invested
at year zero and $30 million will be borrowed at year zero at l2%o
annual interest with the loan set up to be repaid over 5 years ri'ith
equal mortgage payments at the end of years 1 tirrough 5. However, if
the property is sold at year 3 the remaining loan principal will be paid
off at that time. The buildings will be depreciated over a 31.5 year life
using straight line depreciation starting in month 1 of year 1 with the
micl-month convention. The equipment will be depreciated using 7
starting in year 1 with the half-vear life Modified ACRS depreciation
gain
on the terminal value (L) is
any
taxable
Assume
year convention.
taxed as ordinary income. For a leveraged minimum DCFROR of 207o
determine whether selling or developing is economically better.
I
l
l
I
I
I
l
$
{I
T
tI
il
end of year 3, the remaining roan principal will be paid off then.
The
minimum DCFROR is 25vo for leveraged investments of this type.
All values
Revenue =7.0
Op. Costs--l.2
Cost Tangibles =1.5 Tangibles=l.0
Cost Intangibles=2.0 Intang -2.0
1.0
2.5
9.0
2.1
L=6.5
Royalties are l5vo of revenues each year. operating costs include all
severance and excise tax. ljvo of total initial reserves are produced
in
year l,167o inyear 2 and l4vo in year 3. Assume intangible well
costs
are incurred in the first inonth of the year in which they occur. Tangible well costs are depreciated over 7 years using the Modified ACRS
rates starting in the year tangible costs are incurred with the half-year
convention. use a 40vo effective income tax rate and assume other taxable income exists against which to use deductions in any year.
fl
I
f,
t
fl
588
11-7
l-8 work Problem I0-10 assum ing 75vo of the $200,000 equipment
cost
will be financed atye* 0 with a ravo interest rate on borrirwed money.
The loan is to be^ paid off over 3 years with mortgage payments
of
interest plus $50,000 principar madl at each of y"ui, -1,
i and 3. The
effective annual leveraged minimum DCFROR
ii
ZSqo.
CF
cash
+550,000
Investment
CHAPTER 12
12.1 Introduction
Irrdi'iduels and businesses have many investment opportunitic,s
in which
thel' carn pLrt available investment capiial to u,ork. Bank
savings accc)unts,
money rnarkei accounts, certificates if deposit and purchase
of a home to
li'e in are the most common investments ior the average individual. However, businesses and many individuals that have
cash to invest above their
sa'ings account and home purchase requirements generally
want to achieve
a rate of retum on invested capitar greater than
can be achieved on government guilranteed bank account tvpe investments. There
is a seemingly
u,endin-q list of possible indir.idual or business invesiments
wittr varying
degrees of risk. Some of these investments might
include common stock,
options on common stock. bonds, debentures, mortgage
loans, commodity
futures, options on commodity futures, real estate
1sI"I as apartment buildings, office buildings, rental properties, farm and ranch
or undeveloped
land), manufacturing and production projects including
oil and gas and min_
ing development to name a few commo, iru"rt-.nts.
There are very significant diff-erences in the risk associated with the previous
mentioned invest_
rnents. All invesnnents ir.olve risk but sorne involve
much lzigher levels of
risk than others. Trading options on common stock, foreign
currency or
options on futures are examples of investments involving
higher levels of
risk. You may double or triple your investment capital quict<ty
rn option and
lutures i,vesrrnenrs but it is equalry likely that yo, *uy
rose all of your
investment capital. Seldom is there a free iunch. ir you g"t
trr" opportunity
to make money fast in investments such as options und
fr*tur"r, you also run
the risk of losing money fast in these investments. once
a majority of people understand the risks associated with options and
futures"investments,
590
591
592
593
effect of compound interest. This maxirnizes the likelihood that you will
accumulate a personal net worth that will enabie you to cover special financial re.quirements such as sending children to college, meeting major illness
costs. taking special vacations, retiring early or retiring at the normal time
r.'n
c-Ood incr')me.
594
Rule I . Decide whether you should invest in common stocks at all due
to
inherent common stock ownership risks. volatility in stock priies requires
that you be prepared financially and mentally to ride out mariet declines.
It
may be several years before increasing earnings and cash flow in the companies in which you invest are reflected in higher stock prices. If your
plans
include a need to pull your money out of the market to Luy a house or send
a child to college, you are not ready for common stock investments.
Rule 2. Invest with a long-term prospective. No one has a crystal ball to
consistently predict future stock market moves. over the short term (less
than a year), the stock market as a whole, and the individual stocks that
make up the market, may go up or down in price or remain unchanged.
However, over the long run of many years, increasing company
"urnirg,
Rule 3. Do your homework to find companies with rong term net income
and cash flow earnings growth prospects. utilize brokerage house information, cbmpany annual and quarterly reports, Standard and Foer's reports
and
five year earnings data, stock investment service reports and data, and any
other source of information to find companies with at least five years of
consistent past net income and cash flow earnings growth that exceeds 10
to
12 percent per year. Then use your judgement to select the companies
that
have the greatest potential to continue their earnings growth in the
future.
Rule 4. Do not worry about forecasts
for the general economy, stock market or interest rates. over the past thirty years the common stocks of companies with consistently good earnings grorvth have had consistent
increases
in stock price during both good and bad economic times. of course, everyone wants to buy at the bottom of a stock price decline and to sell at the
top.
There is no question that over the short term, business cycles, interest rate
changes and other factors may affect stock prices. However, in practice no
one has the clairvoyant vision to predict when stock market tops and bottoms will occur. Systematic investing in the common stock of companies
with projected future earnings that are expected to consistently increase is
the best key to successful common stock investing.
Rule 5. Diversify your int'estruents over no
59s
of risk bv diversification. 'fhe upside impact on your common stock portfblio is reduced from
a better than expected pertormance by one stock. [n other words. with diversification, you accept reduction in maximum profit potential to reduce the
ilar imum expected loss.
Rule 6. Continue to ruonitor rour common stock investments after ypy l21ay.
Ivlonitor vour investments on a regular basis lor the increasing net income
and cash tlow earnings performance that have been the basis of your investment. If earnings prospects turn negative for the long term, sell, even if the
stock has declined in price. It probably wilt go even lower in price if earnings turn sour. The wall Street axiom "take your losses and let your winnings ride" is based on this logic.
Sixteen blue chip companies that have had eamings per share of common
stock and stock price plus dividend growth rates between l2vo and 307o compounded annually over the past 10 or more years in alphabetical order are:
1. America
On-Line
2. American International
3. Amgen
-X. Ciscc Sysiems Inc.
,5.
Detrl Computer
6. General Electric
7. Intel
8. Johnson
& Johnson
Group
9. Lucent Technologies
10. Merck
1
1.
Microsoft Corporation
12. Paychex
i3. Pfizer
14. Schwab (Charles)
15. Sun Microsystems
16.
Wal-Mart
596
share
has
traded in a range of price-earnings ratios from ten to twenty
with an average
for a twelve month period. If a given stock over the last thirty years
of fifteen, you might conclude that the stock currentty is rairty valued
or
undervalued if the current price-earnings ratio is fifteen or less.
A price-
earnings ratio greater than fifteen may indicate that the stock
is overvalued.
Price-earnings ratio is just one measure of relative stock value
and must
always be considered in conjunction with future earnings growth potential.
A higher price-earnings ratio may be justified for u .to.f wltrr nign
earnings
i.rn
597
''long" signifies
''cover your short sale" (buv back the contmon stock security previously
sold short) at a lower price. The Wall Street axiom "he who sells what isn't
his'n. buys it back or goes to prison" is based on the fact that every short sale
must eventually be covered. Loss potential is unlimited from short sale transactions if stock price goes up instead of down. "Shofi position" is the amount
of stock that investors are short and not covered on a given date. Following is
an iilustration of profit or loss resulting from a "round lot" (100 shares of
comrnon stock) long and short sale transaction
Going back to the I9th century, stock prices in the U.S. have been quoted
on a fractional basis with pricing expressed in 8ths, l6ths,32nds and 64ths.
However, the Securities and Exchange Commission (SEC) has ordered the
stock exchanges and the National Association of Securities Dealers (NASD)
to submit a plan of gradually converting stock prices to a decimal system.
This conversion system is known as decimalization, and is expected to be
fully irnplemented by April of 2001.
598
Solution:
1A) Buying at $50 per share and selling at $60 per share results in
a $i0 per share profit multiplied by 100 shares equalling a
$1000 profit.
2A) Selling short at $50 per share and covering the short at 960
per share results in a $10 per share loss multiplied by 100
shares equalling a $1000 loss.
1B) Buying at $50 per share and selling at $40 per share results in
a $10 per share loss multiplied by 100 shares equalling a
$1000 loss.
28) Selling short at $50 per share and covering the short at 940
per share results in a $10 per share profit multiplied by 100
shares equalling a $1000 profit.
Short sales may be made for speculative reasons in an attempt to profit
from an expected future decline in stock price or a short sale may be macle
for hedging purposes on stock that you already own to lock in a profit.
Assume you own shares of a stock that has advanced significantly in price.
Further assume that you feel the stock price has peaked, but to avoid having
the sale profit on this year's tax return you do not want to sell now. "selling
crgttirtst tlte box" involves making a short sale on stock that you own to lock
in the profit. If the stock price drops money is made on the short sale but an
equirl sum is lost on the stock you own. If the stock price goes up, you profit
on the stock you own but lose an equal sum on the short sale. The "selling
against the box" technique gives a hedging method of locking in profit on
stock or other assets which you own and in which short sale transactions
can be made. As a result of the Tax Revenue Act of 1997, "selling against
the box" to defer tax on the sale of a security was made illegal.
Short sctle transactiorts in comnton stock can only be made on up-ticks.
"Up-tick" is a term used to designate a transaction made at a price higher
than the previous transaction. Conversely, "dox,n-tick" is a term used to designate a transaction made at a price lower than the preceding trade. " Et'en tic.k"
is a term used to designate a transaction made at a price equal to the preceding trade. The reason for restricting short sale transactions to up-tick trades is
to prevent short sellers from depressing stock prices in a down market. This
happened in the 1929 stock market crash. It was after the 1929 crash that the
Securities and Exchange Commission (SEC), which administers U.S. securities laws, established that short sales could only be made on up-ticks.
s99
Ccr;rmissions must be paici ttrr the purchase and sale and short saie of
corrlnlon stock, mutual funds and oprions. Foliowing is a typical 1990 discor:nt broke r comnrission schedule.
Amount
$0*2,499
52,500-6,249
56.250-19.999
$2u,000-49,999
550.000-499,999
$500,000 or
more
Commission
$30 + 1.70Vo of principal
$56 +0.66Vo of principal
$76 + 0.34Vo of principal
$100 + 0.22Vo of principal
$155 + 0.l1Vo of principal
$255 + 0.09Vo of principal
o49
50-149
150499
500-1,499
1,500+
1.
10 per contract
+ 1.507o of principal
+ I .807a of principal
$0-2,499
$2,500-9,999
$ 10,000+
600
of the risks of buying and selling options are the same for all types of
options, although some special risks may apply separately to each type.
"Put and call options" are legal contracts that give the owner the rtgii to
sell (a put) or buy (a call) a specified amount of an underlying asset at a
specified price (called the exercise price or strike price)
for a specffied time.
options that can be exercised at any time before they expire are ctmrironly
called "American-style options". They are different than ,'European-sryll
options" which can be exercised only during a specified period before expiration. The discussion in this text relates primarily to American-styte
options.
The "option buyer" is the person who obtains the rights conveyed by the
option for a fee called a "premium". The buyer is scmetimes referred to as
the "holder" or "owner". since options are legal contracts.there must be an
option writer. For receipt of the option premium fee the writer of an option
is obligated, if and when he or she is assigned an option exercise, to perform according to the terms of the option. The "option writer,,sometimes
is referred to as the "option selrer" and may be an individual, corporation,
trust or other organization.
call (and put) options on common stock give the holder the right to buy
(or sell) 100 shares of common stock at a specified strike price fo. a
specified time. The terms "corutract" and "option" are inteichangeable and
involve rights to buy (call) or seil (put) 100 shares of common srock. call
holders usually only make money if the price of the underlying asset
increases since that generally causes the price of the call option to increase.
Put holders usuallv only make money if the price of the underlying asset
decreases since that generally causes the price ofthe put option to increase.
601
$6 per share when it is sold, or B) the put price is $0.50 per share
when:it is sold. Calculate,the profit or loss from these call and put
:"2
"'raCtiCnS
602
EXAMPLE 12-3 Put and Call lntrinsic Value and Time Value
Determine the intrinsic value and time value for initial and final put,
call and stock prlces described in Example 12-2. lnitial January XyZ
stock price was $49 per share when a person acquired 1) an April
XYZ call at a $50 strike price for a premium of $2 per share or 2) and
April XYZ put option at a gbO strike price for a premium of g3 per
share. Final February xYZ stock price was $s5 per share when A)
the call price was $6 per share and B) the put price was $0.50 per
share.
Solution:
The initial call premium of 92 is entirely time value since intrinsic
value is zero. A call giving the right to buy XyZ at a strike price of
$50 has no intrinsic value when the stock can be bought in the open
market at the current XYZ market price per share of $49 per share.
The initial XYZ put premium-(price) of $3 per share is partiaily time
value and partially intrinsic value. The right to sell XyZ stock at a
strike price of $S0 per share is worth g1 per share when the stock
would have to be sold at $49 per share in the open market, therefore
intrinsic value equals g1 per share. The difference in the $3 put premium and the $1 intrinsic value is g2 per share time value.
The final XYZ call price of g6 per share is $5 per share intrinsic
value and $1 per share time value. With the XyZ stock price at g55
per share, the call giving the right to buy stock at $50 per share
could be exercised with the purchased stock simultaneously sold at
the $55 per share market price. This gives a $S per share intrinsic
value that could be realized from exercising the call option. The difference in the $6 per share premium price and $S per share intrinsic
value is the $1 per share time value.
The final XYZ put price of $0.50 per share is entirely time value.
When stock can be sold in the open market at $SS per share, the
right to sell at $50 per share through use of the put has no intrinsic
value.
603
1r buying '100 shares of the XYZ stock, or.2) acquiring call options at
a $30 strike price for $2 per share, assuming that you expect the
XYZ stock price to increase. Alternatively, if you expect the XYZ
stock price to decline, you could use the $3000 as a reserve for, 3)
cc,rering potential loss from the short saie of 100 shares, or 4)
accr:iring put options at a $30 strike price for $2 per share. Calculate
the potential profit or loss from the foui'possible transactions if:
A) The stock price rises to $40 per share, the call price increases
to $10 per share and the put price declines to zero.
B) The stock price drops to $20 per share, the call price drops to
zerc and the put price increases to $10 per share.
$olution:
The stock price increases to $40 per share for 1A through 4A.
1A) Buy Stock Pro{it = ($40 sate price-$3O initial cost)(100 shares)
= $1,000 profit
($1 ,OOO profiV$3,000 cost)(100%) = 33.3% gain
3A) Short Sale Loss = ($30 sale price-$4O cover cost)(100 shares)
= $1,000 loss
($1,000 loss/$3000 cost)(100%) = 33.3% loss
44) Put Option Loss = ($0 sale price-$2 initial cost)(1500 shares)
= $3,000 loss
($3,000 loss/$3,000 cost)(100%) = 100% loss
The stock price decreases to $20 per share for I B through 48.
1B) Buy Stock Loss = ($20 sale price-$3O initial cost)(100 shares)
= $1,000 loss
($t,OOO loss/$3,000 cost)(100%) = 33.3% loss
28) Call Option Loss = ($0 sate price-$2 initial cost)(1500 shares)
= g3,000loss
($3,000 loss/$3,000 cost)(100%) = 100% loss
604
38) Short Sale Profit = ($30 sale price-$20 cover cost)(100 shares)
= $1,000 profit
33.3% gain
48) Put option profit = ($10 sale price-g2 initial cost)(1500 shares)
($re,ooo
protivgslBlt::,olfifJ't, =
40oo/o
sain
It is clear that acquiring the XyZ stock or call options on the stock
makes money if the XyZ stock price goes up, while selling short or
buying put options makes money if the xyz stock price drops. Also
notice that the leverage associated with options compared to buying
or short selling (control of 1s00 shares versus 100 shares in this
case for the same $9,000 investment) causes a much higher percentage gain and loss with options. options give the investor the
opportunity to make money faster and to lose mbney faster than with
direct buy or short sale transactions.
12.3a Writing Put and Call Option Contracts
There are two sides to every legal contract. For every buyer there must be
a seller. with options,the seller is the "optionwriter,, who receives a premium for granting the buyer the right to buy (call) or sell (put) 100 shares
of
common stock at a specified exercise price for-a specified period of
time.
The primary reason for writing options is nor necessarily highly speculative.
It often appeals to the investor in quest of enhanced income fiom available
investment capital. The buyer of options may have a variety of reasons
for
purchasing options including outright speculation, insuring profits, limiting
losses, tax considerations and so forth. The seller or writer of options
usually has just one motivation, to earn extra income on investment capital
through the premium received for writing options.
consider that you have a "bullish" view of the market and wish to
enhance your return on available investment capital. you feel that the
XYZ stock price is going to increase from its current price of
$40 per
share. You write a 9s day put option on XyZ at a strike price of g40 for
which you receive a $2S0 premium. lf the stock price goes up as you
project, the put option will not be exercised and you wiil realizea
$2so
Solution:
You have written a put option agreeing to buy 100 shares of xyz
at s40 per share. lf your option is exercised you must pay 94000 for
100 shares of XYZ. A premium of $250 was received foiwriting the
option ntaking your net cost per share $37.50. The market is now
valuing the stock at $30 per share so you will have a 97.50 per share
ioss or a total loss of $7S0 if you sell the stock.
This example has illustrated the loss to the writer from exercising
the option near its er.piration. Both writers and buyers of options can
limit losses or take profits without going through the exercise proceoure. They can simply liquidate their positions at any time before the
option expires. The option buyer selis an option with the same strike
price and expiration as the one being held. Likewise, the option writer
buys an option to cancel the one he wrote to liquidate his position.
EXAMPLE 12-6 Writing (Seiling) A Cail Option
606
Solution:
Exercising your option requires you to deliver the stock to
the
option holder for 940 per share. you arso received a premium
t". ot
t9^p"r share, so you receive a totat of $43 per share insteao of tho
$50 per share that you could have sold at if you had not written the
call option. This is an implicit loss of g7 per ihare or a total loss
of
$700 per contract.
when the call writer owns the stock that the option is written against, the
call option is referred to as a "covered option". when the call writer
does
not own the stock against which the option is written, the writer
must buy
the stock in the open market if the option is exercised and
the call option is
referred to as a "naked option". Naked option writing is the
riskiest form of
option writing with unlimited loss potential.
. There are two types of combination option positions which invorve positions in more than one option at the sami time. A ,,straddle,,involves
writing or buying both a put and a call on the same underlying asset,
with the
options having the same exercise price and expiration da-te. A ,,spread,,
involves being both the writer and the buyer of th" ,u." type
option (put or
call) on the same underlying asset, with the options traving different
exer-
The "option expiration date" for common stock put and call options
on
individual stocks and indexes of stocks is the Saturday immediately
following the third Friday of the option expiration monrh.
"Rights" and "warrants" arc similar to call options
but generally are
issued to provide investor incentive that enhances new fund
riising ptt"rtial. when a company wants io raise funds by issuing additional securities
it
sometimes gives its existing stockholder s the " right; to buy the
new securities ahead of other investors in proportion to the number of
shares owned.
The document evidencing this privilege is called a ,,right',. Rights
usually
give stockholders the right to buy new stock below the market
value, so
rights have a market value of their own, are actively traded and
usually have
a relatively short life. "warrants" are similar to rights
but may be good perpetually instead of for a finite period.
stock splits and stock dividends usually are accounted for in options
trading
by adjusting the number.of options shares proportional to the
sto& sprit or dividend. A"stock dividend" is a common stock dividend paid in
securities rather
than cash. A"stock split" is a division of the outstanding
common stock shares
of a corporation into a larger number of shares. with a three-for-one
split by a
507
ci)mpanv. each shareholder gets two new shares for each existing share, so the
shareholder ends up with a total of three shares for each one existing share. On
t!,.e dav the thr-ee-for-one stock split is effective. the price per share of cornmon
\tock is reduced to one-third the closing price at the close of trading cn the previr)ui de)'. The investor orvns three times as many shares at cne -thirC the price,
so vaiue is r"urchanged. Put ard cali options are adjusted simiiarly. On the dal a
litree -lirr-one option is efreclive, e:rch old put or cail ontion contrcis three-hundred shares at one-third the strike price of the originai one-hundred share put
o;'call optiorl contract. The Options Clearing Corporerion has the final deci-
sion on option adjustments for stock splits and stock dividends but option
adjustments normally are proportionai to the common stock adjustments. In
the case of a 25Vc stock dividend which would involve a company issuing
trventy-five new shares for each existing one-hundred shares, old put and call
contracts would controi one-hundred-twenty-five shares after the stock diviclcnd ai a strike price of four-fifths of the originai stnke price.
.!2.3b
Index Options
608
Hedging
609
FUt ootions every month or two and replacing them with longer life
options may reduce the hedging cost.
Index options also are utilized in trading strategies that attempt to
apcly arbitrage techniques. "Arbitrage" is a technique employed to
take advantage of differences in price to lock rn a profit' "Programmed trading" involves rnonitoring the prices and values of the
stocks that make up a Stock index as weli aS the value of the index.
Sometimes differences occur in the values of the index and underlying common stock values so that simultaneous sale of the index and
purchase of the underlying stock (or purctrase of the index and
simultaneous sale of the underlying stock) will lock in a profit. To
610
pr"*i*
"*.nrnl"
Solution:
gffi I:i::
Hedging
611
market. However, the original call cost 3.5 cents per unit so
we have a loss.
Lcssiunit = $.03 final price - $.035 initial cost = -$.00S profit
Total Loss = ($.005/unitx50,000 units) = $2S0
Even though the Australian dollar st;"engthened you lost
money on this call because the 3 cent per unit time value in
the call premium was greater than the 2.5 cent increase in
intrinsic value.
l) hedging commodity price fluctuation risks or 2) price speculation for taking advantage of potential commodity price movements.
The "brr.r'cr oJ' a.fi$ures c:oriract" (.the part1, with a long position) agrees
on a fixed purchase price to buy the underlying commodity (for example,
gold, u.heat or T:Bonds) fiorn the seller at a future contract expiration date.
The "seller of afutures contract" (the party with a short position) agrees to
sell the underlying commodity to the buyer at a fixed sale price at a future
contract expiration date.
"Futltres contracts" are legal contracts to buy or sell a specified amount
of some commodity at a specified price for delivery at a future contract
612
2.
do
the futures contract represent?
3. Which exchange handles the futures trades?
4. In what month and on what day do the contracts
expire?
5.
is the monetary value of the smallest move the contract
can make?
!_hat
6.
one day?
profit.
Hedging
613
82) Selling gold at $440 per ounce and buying it back at $400 per
ounce gives a $40 per ounce profit, times 100 ounces equals
a $4,000 profit.
trl
10',1, t,: 15Vo of the underlving tirtures contract dollar value. Some brokers reltr to the margin requirement on futures as a "good faith deposit"
since thcre is no cost rncurred until the future transaction is completed by
either erecuting the futures contract or making an offsetting transaction.
N'Iinirnunr margins are set by the exchanges for different commodities and
may be adjusted periodicaiiy due to commodity volatility changes. Notice
that in the last E-xample L2-10, the investor bought or sold gold futures at
$4-lt) per ounce) so each 100 ounce contract had a value of $44,000. with a
iu% rnargin requirement the investor put up $4,400 equity margin to realize
a' l3S9b return ($6,0001$4,40t,)( 100%) on equiiy invesrment in .A1,, and
1-a6?o loss (-$6,000/54.400)(1007o) on equity investmenr in "81". It can be
seen that percentage gain or loss on y our equity investment in futures contracts can be very large and is limited only by commodity price movement.
"I'led|:ers" and "speculators" are the two basic caiegories of futures
contract inl'estors. In general "hedgers" use futures for protection against
advcrrse tuture price movements in the underlying commodity. The rationaie
oi hc:dging is based upon the demonsrrated tendency of cash commodiry
spot price: and futures plices to move in tandem. Hedgers are often businesses or individuals who deal in the underlying commodity. Take for
example a breakfast cereal producer that requires wheat and oats for cereal
processing throughout the year. For protection against higher wheat and oat
prices that could occur due to drought in the farm belt or increased sales to
a foreign country the processor can "hedge" the risk exposure by buying
wheat and oats contracts to cover the amount of grain that is expected to be
boucht in the future. If grain prices rise. profits on the futures contracts will
otTret the higher cost of grain, locking the price in at today's future contract
price. Frnancial institutions, pension funds, insurance companies and corporations hedge their common stock and bond portfolios against market down
turns by selling stock index futures, T:-Bond or T-Bill futures. This is analogous to the use of index put options for portfolio insurance discussed in
Example l2-8. If these same organizations have future financing requirements they can hedge against interest rate increases by buying T:.Bond or
T-Bill futures.
614
"
615
Brtth v'riters end buyers of options c(m linit losses or tetke prt{its at an)'
time by liquidating their positions at any time before the option expires. To
i1.; this. the option b,,ryer" sells an option with the same strike price and expiration as the one he is holding and the option writer buys an option to cancei ili,: one he wrote.
616
Sate price/DM
Sate price/DM
By buying
equals
business interests.
617
loans dtte
re,:t' or ,,short term liabilities" are accounts pttyable, notes and
are tlle
debt")
"funded
within one year "Lang term liabilities"(also called
!
ot,. t, i:
"fr;ill
fl
f,
ond,preferredstockholdersthird,andcommonstockholdersarelast.Commonstockinvestmentgivesthegreatestrewardpotentialfrompossible
stock value' This
increasing tlividends ani capital appreciation in common
the investment
losing
of
risk
greater reward potential is bffset by greaier
stock investpreferred
o.r
frincipal in comparison with bond, debenture
ments.
618
debentures".
619
nients are perceived to be antong the safest investments in the r,vorld today
and, as a result, are often used as the basis for a risk free rate. Conventional
-l-rca:;rrrv
or corporate bond interest rates are paid semi-annually witn maturitv virlue equal to the face value of the bond. All bonds issued since the midi')o0's :ue registeretl bonds. " Registeretl boncls '' are botrds that are registered
orl the books of the issuing companv or go!'erntnetrt organization in the nrne
rii thc ()\\'ner and can only be transferred to a new owner r.r'hen endorsed by
the iJqistcrecl owner. "Bearer bonds" are not registered on the books of the
i\siiins company, so the bearer of the bon<i is the owner. No signature is nec-
I
l,
ess:rry
1980's Congress outlawed the issuance of new bearer bonds, but bonds in
existence at the time of the law change rvill be traded for another twent)' to
trt'enry-five years. Beorer bonds are "coupon bonds"; bonds with coupons
attlched. The coupons are clipped as they come due and are presented by the
hoidcr for payment of interest (usually through a local bank).
''Zt:ro coupon bonds" are bonds that pa)'no semi-annual dividends; the
diviciend coupons have a value of zero. Ztro coupon bcnds can be created
by stripping the dividends from the maturity value and selling the rwo cotnpondnts separateh', or by setting up a new bond issue on a zero coupon bond
basis. Zero coupon bonds are sold at a discount from face value.
A conventional $10,000 U.S. Treasury,30 yeai bond will pay dividends at a rate of 8"h compounded semi-annually. What are the present values of the dividend stream and the maturity value respectively?
Solution:
Conventional
BonC
C=$'10,000
Piv=$400. . . . Div=$400
Maturity Value = $10,000
...60semi-annualPeriods
22.623
PW Div. = $400(P/A4,60) = $9,049
.0951
620
1oiil;;',"
r"r,r,"ii
G;;"
C=$1O,OOO Div=g4gg. . . .
Div=g4g6
;-------. . . . ousemr_annualperiods
_ Maturity Vatue = $10,OOO
18.929
= $400(P/A5,60) +
.0535
$10,000(pf;6)
= $8,107
li:l.,rer
'12:
c=$10,00c
Ze';o
C:r, li,,cn Bond
$8,107)/$10,000](100%) = 18.93%
Maturity Value = $105,196
1 . . . . .. . .. 60semi-annualPeriods
.0535
$105,19S(P/F5,69)
= $5,628
=
il
Bonds
compare the after-tax future value accumulated 5 years in the
future from investment of $10,000 in a 9% annual interest rate,5
year zero coupon bond, ot d 7.650/o Series EE Savings Bond. The
622
Solution:
Accrued Taxable lnterest per year
Zero Coupon C=$i0,00e
_Q9gg $981 $1,06g_ql1qq__$l?70 Maturity
Bond,9"/"/yrffi4sVarue=g15,3g6
lncome Tax @
38./"
$288 $314
comparison.
Series
EE
Bond, 7.65% yr
$373
$406
Maturity
Value=?
. zaa6)ilf,lu,o1
1.2475
1.1589
+ Bt4(F/p7.65,g) + 342(F1p7.6S,2)
,.zzss)!131,,I .406
= g16,0s3
623
This Series EE Savings Bond future value of $'14,654 after taxes is less
than the zero coupon bond future value of $15,386 after tax, so the
zero coupon investment is economically preferable, Flemember that
these numbers are to illustrate general concepts and methods only.
Tne analysis should be re-run for actual savings bond and zero coupon
bcnd rates that are applicable at the time of your investment decision.
''lvlttrticipal bonds" (or "ta-r exempt bonds") are the bonds of state, city,
count) and other public authorities specihed under federal law, the interest
on whrch is either wholly or partly exempt from federal income tax and
sometimes exempt from state income tax. Whereas the accrued interest on
Series EE savings bonds is tax deferred to the future time when the bonds
are sold, municipal bond interest is "tax-tiee". The only exceptioir is related
to municipal bonds that are subject to alternative minimum tax. If the funds
irom nrunicipal bonds are used fbr private development purposes rather that
publlc pLrrposes, thase municipal bonds are subject to aiternative minimtrm
tax ruies for individuals or corporations, which may cause part or all of
rnunicipal bond interest to be taxable. It is advisable to check with a tax
accountant or knowledgeable broker concerning alternative minimum tax
status of specific municipal bond issues belore investing.
As in comparing the tax savirigs of Series EE Savings Bonds to zero
coupon bonds, the potentictl tax savings o1 "taxfree" ntuticipal bottds arc
n()t reLt|lr tux-fre e. Int,e.stttr',; accept irtte rest rates in municipal bond investntents tlrat tvpicaily are sey'eral percentage points less thctn can be obtainetl
in conventional taxable bond investn'Lents. Therefore, implicit tax is actually
being paid on municipal bortds. The public municipalities benefit from the
lower interest rates that investors are willing to accept to avoid paying tax
on the interest.
624
Solution:
Zero Coupon Bond year 5 Value $15,gg6 after-tax,
=
from Example 12-14
year
Municipal Bond
5 Value
1.4356
1.33ss
1.2423
1.1556
of highly
importance.
625
626
627
or sell (or buy) on a stop ortler. If the order is executed upon the
bappening of one alternative, the order on the other alternative is treated as
cuiriclle,l. Il the order is for an amount of securities larger than one unit of
t:.r,-ling. r-he nitmber of units erecuted determines the amount of the alternari'.e oldcr to be treated as cancelled.
Iimit
1:r'ice
to equ:l1. ratio) mr:st also be usecl in all evlluatiorr.i if they are not being
done t.p a cash equity (l00%c rnargitl) investment basis. Fair snalysis comparison of tax deferred, tax tiee and taxrible inyestments requires very careiul handling of the after-tax analysis income tax considerations.
For investors in all tax brackets the tax deferred aspects of investments in
and
a traditional individual retirement account (IRA), tax deferred annuities
pension plans create very complex and competitiye alternatives with many
other taxabie income aiternatives liom earnecl interest in bonds or CD's or
taxal-.le income tiom investment opportunities. The Roth IRA is somewhat
inverted to a traditional IRA. With traditional IRA'S' initial investments up
to the limit amount are deductible from ordinary taxable income in that year
and r,, ithdrawals after age 59Vt ate taxed as ordinary income' With a Roth
lRA, initial investments are not tax deductible and withdrawals aftet 59Vz
are not taxed. In fact, you can withdraw the equity invested in a Roth at any
time and not be subject to tax or penalties. Below is a summary of some of
the principal features differentiating a Roth IRA from a Regular IRA as of
late 2000:
628
Traditional IRA
up to $2,000 may
a
a
withdrawn.
Mandatory minimum distributions enforced at ageTOr/2.
No contributions allowed after age 70y2.
For anybody other than a spouse that might inherit an IRA, the amount
of the IRA may be subject to both estate taxes and ordinary income
tax on any subsequent withdrawals from the account.
In qualifying to contribute to a traditional IRA individuals and married
couples are subject to constraints on their Adjusted Gross Income
and
any participation in an employee sponsored retirement program.
Roth IRA
and t-ederal income taxes each year. This is probably the only significant drawback of a Roth, relative to a traditional IRA.
Investors may withdraw r00vo of the accumulated investment (equity)
at any time and not be subject to any penarty or tax. only the accrued
interest or wealth must remain in the account.
while intended for retirement, after five years you may elect to withdraw up to $10,000 for down payment on a new home. This is
nor subject to any penalty or other tax. This could make opening
a Roth for
children earned income very desirable.
A child with earned income can invest each year in a Roth IRA the
lesser of their earned taxable income for the year or
$2,000 (in the year
2000). If a child has no earned income for a year, then no Roth
IRA
deposit can be made. However, the deposit to a Roth IRA could
come
from a gift from parents or grandparents and still qualify provided
the
child's earned income really exists! For children under lg the creation
of a Roth IRA will require a custodial account and proof of income
such as check receipts, w4 or w2 forms. Each brokei will likely
have
their own proof of income requirements to establish the account.
After 5 years, at age 59vz any amount may be withdrawn from a Roth
tax free. No limitations exist.
o
o
629
A) The individual opens a traditional IRA and invests the beforetax salary in a conservative governrnent bond mutual fund that
is anticipated to earn 8.0% before taxes per year for the next
20 years. Tax on any income is deferred until the account is
liquidated which is assumed to occur 20 years from today'
B) The individual opens the same traditional IRA but invests the
before{ax salary in a growth fund that is anticipated to grow at
12.O"/" per year for the next 20 years before taxes.
530
Solution:
A) Traditional lRA, Earning g.O% per year
with the traditional lRA, taxpayers have the ability to keep 1oo/o
of their tax dollars working until retirement 20 years from now
45.7620
......20
F = $2,000(FlAg/".2g)
= $91,524
= 63,152
......20
631
1-20
Ta;<able Saiary
2,000
- 620
1,390
$1,380
$1,380
. $1,380
2......2A
45.7620
F = $1,380(FiAg..z..29)
= 963,152
is the increase
72.0524
$1,380 $1,389_:!180
F = $1,380(F/A1 Z"/",20)
......20
= $99,432
This result is the same as the case B traditional IRA result for a
319i, tax rate in year 20.
E) Ordinary Taxable lnvestment in Common Stock
The disadvantage here is that not only is your salary still taxable,
but now the gain realized 20 years from today would also be taxable
at the applicable long-term capital gains tax rate assumed to be
15.09'. for this example.
632
Year
Taxable Salary
- lncome Taxes @ 31%
After-Tax Salary (ArcF)
$1,380
$1,390.
Year
Net lncome
+ Stock Book Value
ATCF
1-20
2,000
620
1,390
72.0524
$1,390
2........20
$Lil3f^12/",20)
20
99,432
-27,600
71,932
-10,775
6'1,057
27,600
88,657
"*u*pr".
633
I
il
-&-
634
63s
Solution:
Whole Life:
,,.^
l:tt,t.
'10.
. 19
-$1,600 -$1,600
20,
,29
$1 62,1
50
30
-$328 -$328
-$328
'1.
-DO lO
'10.
-$61 6
. 19
-1,346
20.
-$1,346
$o
29
30
Vi;bole Life-Term:
.9
10.
-$eB4
-$254
-$254
+$162 150
10
2A
29
30
636
.
.
.
.
.
.
.
.
.
.
.
in a valid after-tax
,;
,:,i
Chapter
l2
637
5500 with annual maintenance estrmated to be $1,000. Horne maintenance and insurance costs are not allowable itemized deductions,
but the home loan interest and pro.perty tax v''rill be taken as iternized decjuctions for federal and state income tax calculation purposes in iieu of using the married joint return standarci deduction of
57,350. Assume the individual ef{ective federai plus state tax rate is
30.0% Assurne that the year 5 sale value of $180,000 less real
estate sale commission is not taxable per current tax law. The couple assumes that other places exist to invest money at 10.0% per
year after-taxes and that the risk in those investments is equivalent
tc investing in the home. lf the couple rents, assume end-of-year
annual rent ccsts of $12,000 in years 1 and 2, $13,200 in years 3
and 4, and $14,000 in year 5.
Solution:
Home Purchase Cash Flow Analysis
Annural 30 year mortgage payments = $120,000(A/P1O,3O) =
$12,730. These annual mortgage payments break down into annual
interest and equity principal amounts each year shown in the cash
florry calculations.
638
Year
-llor]9a,9e_tnterest
-
Property
Tax
-1,500
Taxable lnc.
-Tax
30o/o
_11,6a7-_17561651
_12,000 _11,927
*:]]::-"i"
- lnsurance
- Maintenance
- Principal
Amount 120,000
price -15o,ooo
_500
-114'543
+ Sale Value
180,000
Commission
CashFlow
30,000 _11,680-1
,tgt
_11.296 _11,8;B
-12,600
;0Sg5---
+ 11,796(piFt0,g)
+ Loan
- Purchase
vrvv
4, 400
p/F
1
g, 5 )
is
639
tions would be $2,200 per year. so the dtfference in the $7,350 stanijard deduction and $2,200 is a foregone $5,150 deduction if a home
is bought and deductions are itemized. A $5,150 deduction in each
o{ years 1 through 5 would save $5,150(0.30 tax rate) or $1,545 per
5iear in tax savings. The present worth of these tax savings is
$i,545(P/A10,5) = $5,858. lf the present worth home purchase cost
is increased hy the 55,858 opportunity cost from foregone tax savings due to itemized versus standard deduction, the adjusted present
v,,orth purchase cost is $47,720, which is closer to the $48,700 rent
nresent worth cost. Carefully accounting for all costs, revenues and
tar effects along with the proper timing of these items is very important to all analyses, including home purchase versus rent analyses.
12.7c Personal Auto Purchase versus Lease
Inciividuals do not get depreciation tax deductions or lease payrnent
expense deductions on personai automobile costs. Interest pzrid on money
borrr-rrved to finance personal autos is not tax dcductible under current tlx
larv in i993. Therelbre. the after-tax cost of providing automobile service is
the same as the before-tax cost for purchasing with cash, purchasing with
bonowed money, or leasing. This is very difl-erent than the business analysis
c'f auto lease versus purchase analysis presented in Exampie 10-2 where the
t,rr savings fiom depreciation and operating lease payments were taken into
,rccount as allowable tax deductions. The following example illustrates sevelal decision criteria that can be used to evaluate the leasing versus purchase
ol a personal automobile. These techniques are the same for all types of
vehicles.
(A)
Purchase the car with cash now, at time zero, for $71,850.00.
640
(B) Purchase the car by putting 20% down at time zero and
bor-
Solution:
(1) Present Worth Cost
A)
Cash C=971,850
0. .
..
PWC = 71,850
B) Borrow
20% Equity
.. .36
Salvage = $3S,g2S
0.69892
35,925(p lFft",SA) = g46,741.12
c=$1a,!Zg--c=$'t,854.72.
. . . c=$1r8-54.r2
.......36
s^ru.=$35,92s
where:
0.43227
Loan Payment = [0.8(71,8S0)](A/p0.8333%,30)
= $t ,BS4.7Z
30.1075
PWC = 14,370 + 1 ,854(P/A1
%,36)
0.69892
g5,925(p lF
I
Chaoter i2: Personal lnvestments and Hedging
I
I
I
I
C) Lea:e
LP=$977.81
C=$7,185
LP=$977.81
{
,!
641
.......35
36
29.4086
FWC = B,'tO2.B1 +9ZZ.B1(p1A1"7",g5) = $Qgr9lg,Bl
Nominal
Cash
Borrow
Cost
PW
45,322
40,9'19
4s,323
6%
8%
9%
10%
11%
41,829
42,712
43,568
44,399
45,203
45,984
12"/"
46,741
I OO/
tJ /o
47,476
48,189
48,879
52,036
45,316
45,300
45,275
45,243
45,203
45,156
45,102
45,A42
44,975
44,903
44,463
10/
l/o
14%
15%
20%
$42,386
40,415
39,946
39,487
39,039
38,597
38,165
37,741
37,326
36,919
36,520
36,1 28
35,745
33,934
$45,2'15
J/O
Lease
PW Cost
AC=$6,207 AC=$876:91
AC=$876.91 . . . AC=$1
,854.72
L=$35,925
35............36
Cash-Lease:
AC=$63,687.19 5=$977.81......5=$977.81
'l
.......35
L=$3s,9zs
36
642
=$!9191
Leveraged Break-even:
0.03227 30.1075
0.69892
- O.sx(p/rit;)
= 36,e1e
0.6285X=36,919; X=$gql11
lf the dealer wanted a 15/" return on his or her
investment, based on
the given one time front-end payment, the monthry
r"are payments
and the finar salvage value, whai is the dealer
cost basis in the vehi_
cle?
7, 1 85.
28.2079
0.6394
35) + 35, 925.00( p /F l .ZS"7",SA)
$qel1g.2?
643
Derivative: a security whose value is derived in part from the value and
of an underlying security. put and call options and futures
contracts are examples of financial derivatives.
Dol'ntick: is a term used to designate a trlrsaction made at a price less
characteristics
644
and
in
well.
Indenture: is a written agreement under which bonds,
debentures and preferred stock are issued, setting forth the interest
or dividend rates, maturity
dates, call dates and other conditions such as
conversion terms, sinking fund
money."
security
also be
an investment.
645
as the holder. The buyer is the person obtainirrg tiic rights conveyed by the call option for a fee c:rlled a premium.
r:t {)xlers:
.\li-or-none: is an order to be executed in its entirety, or not at all.
l)ay: is an order to buy or sell a stated amount of a security that, if not
executed, will expire at the end of the trading day.
Fill-or-till: is a market or limit order that is to be erecuted in its entirety
as soon as it is represented to the trading crorvd, or not at all.
Good-tilt-Canceled: is au order to buy or seli wirich remains in effect
1. I :i ;'i..
at a specified irrice, or at a better price after the order is presented to the trading
crowd.
[Iarket: is an order to buy or sell a stated amount of a security at the
most advantageous price obtainable when presente-d to the trading
crorvd.
646
earnings.
Put option: an option contract that gives the holder the right to
sell a speci_
fied amount of an underlying r".uiity or asset at a specified price
(strike
price) for a specified period of time (expiration date).
Registered bonds: are uniquely different from bearer bonds
in that the bond
is registered by the issuing corporation or government in
the name of the
owner or holder. This information is then provided to
the Internal Revenue
Service. All bonds issued today are registered.
short position: the number of common stock shares sord short at given
a
time. Although short se[ers usualry are negative concerning
prospects for
ltock price, analysts often consider a high short position in'a stock to be
bullish for stock prices because shares ,old ,ho.t must eventuaily
be repur-
r.-hased
short sale: invorves selling a stock that an investor may not own,
with the
expectation of being able to buy it back later at a lower price.
sinking fund: holds money set aside regularly by a company or government entity to redeem bonds, debentures or preferred
sto& in accordance
647
'freasury bills (T-hills): are securities issued by the U.S. government with
lives ranging from three to six months. In the past, one-year t-bills have also
been avaiiirble but they are scheduled to be phased out in early 2001 due to
ine declining U.S. debt.
1'reasurl'notes: are secr:rities issued by the U.S. government with lives
tl:;. rii.i ii ;.il ()lt j t., fit e vj.lfs.
'lrtlasurl bonds: are securities issued by the U S. governrne::t with lives
r:rrgine 1i'trn fir'e to thirti,' yeilrs.
i.,'rriversal Iille insurance: see whole life insurance.
[lp-tick: is a tenn used to designate a transaction made at a price higher
than the preceding trade.
\Yhole life insurance: (also known as universal life) this involves a combination of term life insurance and savings plan that has a separate after-tax
vahre.
ll'r-iting a covered call: a strategv by which a perion writes (or sells) call
opliclns while simultnneously orvning the undcrlying secr,rrit';. The rvriter
receil'es the premiu:n frorn the buyer of the cell.
lVriting a covered put: a strategy by rvhich a person sells put options and
simuitaneor,rsly creates a short sale position in an equi'ralent ntlmber of
shares in the underlying security. The u,riter receive-q the premiurrr from tlie
b,.r-ver
of the puts.
share
dir idecl b1' the prurchase pricc of the stock (aiso i:rrown as a dii'id'-'rtd yielJ)
or. in the bond market, the annual interest divided by the purchase price
(commonly known as current yield).
Yield to maturity: is the bond markets definition of the nominal compound interest rate of return being received on a bond investment if held to
maturity with or without call privileges.
Zero coupon bonds: also known as "deep discount bonds" or "strips,"
these bonds pay the owner a single lump sutn of money called "maturity
villue" at a future time referred to as the bond "maturity date." Zero coupolt
hilrriis do n()t pay interest atrnually or semi-annuelly like norinal registered
bonds and therefore, are sold at a discount to the bond maturity value
(maturity'i,alue may also be referred to as "face value").
APPENDICES
A:
B:
C:
D:
E:
vzvo to
i = 2ooro)
t*
I
APPENDIX A
ii
VzTo
A;l;.,u;rt Factor
= F/pi,n = (r +
= p/Fi,n
to i
2007c
i)'l
(r + i)n
(t+r)n-r
F/Ai., _
i
= A/Fi,n
= A/pi,,,
_ i(r+i)n
= P/Ai,n
_(r+i)n-r
Arithrnetic Gradient
= A/Gi,n
(r+t)n-r
(r+i)n-r
i(r + t)n
Series Factor
649
i(r*i)n-r
650
i=
n
I
3
4
5
6
7
8
9
10
11
t2
13
t4
15
16
t7
r8
t9
20
2t
))
23
21
25
26
27
28
29
30
35
36
_10
,15
50
55
60
65
70
75
80
85
90
95
100
FlPi,n
P/Fi,n
1.0050
1.0100
0.9950
0.990r
i.0151
1.0202
1.0253
1.0304
1.0355
1.0107
1.0459
1.0511
1.0564
1.0617
1.0670
1.0723
1.0777
1.0831
1.0885
1.0939
1.0994
0.9851
0.9802
0.9754
0.9466
0.9419
0.9372
0.9326
0.9279
0.9233
0.9187
0.9141
0.9096
1.1 104
1.1 160
0.8961
0.9006
0.8916
1.1272
1.1328
0.8828
385
0.8784
6.0755 0)6460
7.10s9 0.14073
8.1414 0.12283
9.182t 0.10891
10.2280 0.09777
11.2792 0.08866
12.3356 0.08107
13.3972 a.07464
14.4642 o.o69t4
15.5365 0.06436
16.6142 0.06019
17 .6973 0.056s
18.7858 0.05323
19.8797 0.05030
0.9561
0.9s 13
0.9051
t.t2t6
,, F/Ai,n A./Fi,n
1.0000 1.00000
2.0050 0.49875
3.0150 033167
4.0301 0.24813
5.0503 0.19801
0.9705
0.9657
0.9609
1.1049
0.8872
20.9'791
1412
0.87,10
0.8697
0.86 r0
32.2800
1.1907
1.1967
0.8398
0.83s6
38.t4s4
1.2208
1.2516
1.2832
0.1990
o 77q?
I .3156
0.7601
0.8191
r.3489
r.3829
1.4178
1.4536
0.7053
0.6879
1.4903
0.6710
0.74t4
0.72.3t
r.5280
0.65.15
I.-5666
r.6061
1.6167
0.6383
0.6226
0.6013
0.04767
22.0840 0.04528
23.1944 0.0431 I
24.3104 0.04r l3
25.4320 0.03932
26.5591 0.03765
27.6919 0.0361 I
28.8304 0.03469
29.9745 0.0.r3-36
1499
I 556
1614
0.86_s3
0.50clo
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39.3361
44.1588
50.3242
56.64s2
63. I
258
0.0-1:
l.l
A./pi,n
P/Ai,n
1.00s00
0.50375
0.33667
0.25313
0.20301
0.99s0
3.9505
0.4988
0.9967
1.4938
4.9259
1.9900
0.16960
0.14513
0.12783
5.8964
6.8621
7.8230
2.9801
0.11391
8.7't91
L985
2.9702
0.ta277
0.09366
0.08607
0.07964
0.07414
0.05936
0.06519
0.061s 1
0.05823
0.05530
0.05267
0.05028
0.04811
0.04613
9.7304
10.6770
I1.6189
12.5562
13.4887
. 14.4166
15.3399
16.2586
17.1728
18.0824
18.9874
19.8880
20.7841
21.67 57
0.04432
0.0426s
22.5629
23.4456
0.041r I
0.03969
0.03836
25. I 980
0.0371 3
24.3210
44.1428
0.02084
47.9814
0.01933
0.01 806
51.7256
5s.3775
58.939.1
0.01520
0.0t447
0.01383
0.01325
0.01273
4.9501
5.4406
5.9302
6.4190
6.9069
7.3940
7.8803
8.3658
8.8504
9.3342
9.8172
10.2993
10.7806
I 1 .2611
11.7407
12.2195
12.6915
t6.9621
0.03122
0.03042
0.0276s
0.02487
0.0226s
0.01697
0.01602
3.4738
3.9668
4.4589
32.A351
32.8710
0.02622
0.02512
0.01584
2.4855
14.1265
0.03598
69.7700 0.01433
76.s821 0.01306
83.5661 0.01t97
90.7265 0.01102
98.0677 0.01020
I05.5943 o.oo947
I I3.3109 0.0088 3
121.2221 0.0082s
129.3337 0.0077.1
nla
26.0677
26.9330
27.7941
0.03098
0.02265
0.01987
0.01765
A./Gi,n
36.1722
40.2072
62.4136
65.8023
69.107 s
12.3313
75.4757
78.5426
t3.17 47
13.65 t0
16.49 I 5
18.83-59
21.1595
23.4624
25.7 447
28.0064
30.2475
32.4680
31.6679
36.8474
39.0065
41.14-5 I
43.2633
45.3613
i=
n
1
2
3
4
5
$
7
ti
9
l0
r1
l2
I3
14
!5
i6
i7
i8
l9
t0
2l
22
23
24
25
26
27
28
29
30
35
36
{0
45
50
55
60
ri5
10
75
r]0
85
90
95
llr0
.['/Pi,n PlFi,n
t.0100 0.9901
1.0201 0.9803
i.0303 {).9106
i .0406 0.9510
L0-5 l0
0.!)5 l5
i.0515 0.9420
1.0121 a.%27
1.uri29 0.9235
1.09-37 0.9143
1.1046 0.9053
t.115"7 0.8963
1.1268 0.8874
i. I 381
0.8787
1.1495 0.8700
1.1610 0.86 13
i.1126 u.8528
.f .i343 0.8.144
r. i961
0.8360
1.2(i81 tt.8277
1.2202 0.8195
1.2324 0.E I 14
1.2447 0.8rJ3.1
1.2572 01954
t.?-697 0.'18'76
1.:S:4 0.7798
1.2953 d.7710
1.3082 0.7644
I .32 r3
0.7568
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l.l'178 0.74t9
1.1166 0.70s9
1.4308 0.6989
rt.6i tj
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r.s648 0.639 t
1.6116 0.6080
1.7:ti,s t,.5785
1.8 t67
0.5_s04
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2.0068 ().4983
2.1091 0.4741
2.2t67 0.451 I
2.3298 0.4292
2.4186 0.4084
2.573s 0.3886
2.7018 0.3697
651
i.$AVo
F/Ai,n A/Fi,n
1.0000 1.00000
2.0100 0.497 51
i.0301 0.13002
4.0604 0 24528
5.1010 ii 19604
6.1520 0.16255
'/ .2ti5
0.13863
8.2857 0.12069
9.3685 0.10674
10.4622
0.09558
1.5668 0.08645
12.6825 0.07885
13.8093 A.07241
14.9474 0.06690
16.0969 0.c62 t 2
1
A/Pi,n
1.01000
0 507-51
0.3.iu()2
0.256:8
0.206()4
a.t72a5
0.14863
0.13069
0.116
t-1
0.10558
0.09645
0 08885
0.c8241
0.07690
0.07212
17.2.5'79
r E.-1304
0.tr5794
0.05+16
0.057q4
09
22.0t9a
0.0s098
0.04805
0.01542
0.06098
0.05805
0.05542
23.2392
21.4716
25.7163
26.9,135
28.2,.i32
0.04_103
0.040E6
0.03 889
0.0-1707
0.05303
c.05086
0.04889
0.01707
0.03541
0.0.1,s41
0.03387
0.04387
0.04215
0.04112
0.03990
0.03875
19.6117
20.81
29.52-<6
30.8209
32.1291
33.4s04
34.7819
41.6603
43.0169
48.8864
56.48t1
0.03215
0.031
l2
0.02990
0.02875
0.02400
0.02321
0.02046
0.01771
64.4632 0.01551
72.8525 0.01,173
81.66e7 0.01224
90.9366 0.01 r00
100.6763 0.00993
110.9128 0.00902
121.6715 0.00822
132.9790 0.00752
144.8633 0.00690
r 57.3538 0.00636
170.4814 0.00-587
0.064r6
0.03400
0.03321
0.03046
0.02171
P/Ai,n A/GiP
0.9901 nla
1.9-t.)1 0.49i5
2.941C 0.9111
3.9C10 1.1s16
:1.8534 1.9!i) [
5.1955 2.4i i0
61282 1.9602
7.6517 3.1478
8.5560 3.9337
9.1713 4.4179
10.3676 4.9005
r .2551
5,3815
12.t337 5.8601
13.0037 6.3384
13.855 r
6.8143
1
14.71^79
15.56:3
16.3933
17.22*o
18.04-j6
18.85 70
19.6604
20.45-<8
2\.2134
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i]613
5.2323
81017
9.t694
9.6354
1U.0998
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tl.0217
22.0232 il.4831
22.7952 1.9409
23.ss96 12.3971
24.3164 12.85t6
25.0658 13.30-14
25.8077 13.7551
29.4086 15.9871
30.1075 16.4285
?'2.834't 18.1"i16
36.09,15
20.32'73
0.02-55 r
39.l96
2?.1363
0.023;3
42.1472 24.5019
44.9550 26.5333
47.6266 28.5217
0.02221
0.02100
0.01993
0.01902
0.01822
0.01752
0.0r 690
0.0r636
0.0 r587
50.
1685
52.58'71
30.4703
323793
54.8882 34.2492
57.0777 36.0801
59. 1609 37 .8'724
61.1430 39.6265
63.0289 413426
652
i = 2.00Vo
n
F/Pi,n
P/Fi,n
r.0200
1.0404
0.9804
1.0612
1.0824
t.1011
1.t262
r.1487
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8
9
1.1951
t0
1.2190
11
t2
13
14
15
t.2134
1.2682
1.2936
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l.-3,1-59
1
t6
1.3728
1.4002
t7
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t.4282
t9
1.4568
1.4859
20
0.9612
0.9423
0.9238
0.90s7
0.8880
0.8706
0.8535
0.8368
0.8203
0.8043
0.7885
0.7730
0.7579
0.7430
0.7284
0.7112
0.7002
0.6864
0.6730
2t
1.5 I 57
22
1.5.160
0.6s98
0.6468
1.5769
1.6084
0.6312
:3
21
25
26
27
28
29
30
J5
36
l0
J5
50
55
60
65
70
75
80
85
90
95
100
1.6-106
31
1.7069
1.1410
1
.67
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0.6217
0.6095
0.s976
0.58-s9
0.57 44
0.5631
t.t
0.-5521
1.9999
0.5000
0.4902
0.4529
1.8 I
2.0399
2.2080
2.4379
2.6916
0.371 5
2.9117
0.3365
3.28 l0
3.6225
3.9996
,1.4158
4.8754
5.3829
5.943 t
6.)6 l7
7.2416
0.1102
0.30-18
0.276t
0.2500
0.226s
0.2051
0. r 858
0. I 683
0.1524
0. I 380
F/Ai,n A./Fi,n
1.0000 1.00000
2.0200 0.49505
3.0604 0.3267s
4.1216 0.24262
5.2040 0.t9216
6.3081 0. I 5853
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8.5830 0.11651
9.7546 0.10252
t0.9497 0.09133
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12.1687 0.08218
13.4121 0.07456
14.6803 0.06812
15.9739 0.06260
17.2934 0.05783
18.6393 0.05365
20.0121 0.04997
2t.4123 -0.04670
22.8106 0.04378
24.2974 0.04116
25.7833 0.03878
27.2990 0.03663
28.8450 0.03467
30.4219 0.03287
32.0303 0.03122
33.6709 o.o2s7o
35.3143 0.02829
37.0512 0.02699
38.7922 0.02s78
40.5681 0.02.165
49.994s 0.02000
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60.4020 0.01656
7 t .8927 0.01 391
84.5794 0.01182
98.5865 0.010r4
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131.1262 0.00763
149.9719 0.00667
170.7918 0.00586
193.7720 0.00516
219.1439 0.00456
247.1567 0.0040s
278.0850 0.00360
312.2323 0.00320
A/Pi,n
P/Ai,n
1.02000
0.9804
1.9416
2.8839
3.8077
0.51505
0.34675
0.26262
0.21216
0. 1 7853
0.15451
0.13651
0.12252
0.1
133
4.713s
5,6014
6.4720
7.32s5
8.1622
8.9E26
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A./Gi;n
n/a
0.4950
0.9868
1.4752
1.9604
2.4423
2.9208
3.3961
3.8681
4.3367
0.10218
0.09456
0.08812
0.08260
0.07783
12.8493
6.6309
0.07365
0.06997
0.06670
13.5777
14.2919
14.9920
7.0799
7.5256
7.9681
9.7868
10.5753
11.3484
12.t062
4.8021
5.2642
5.7231
6.1786
0.M378
15.6785
0.06116
16.3514
8.8433
0.05878
0.05663
0.05467
0.05287
0.05122
t7.0112
17.6580
18.2922
i 8.9r 39
9.2760
9.7055
10.1317
10.5517
19.s235
10.9_745
20.t2to
11.3910
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8.4073
0.04970
0.04829
0.04699
21.28t3
0.0.1578
0.0,1465
21.8444
22.3965
0.04000
0.03923
0.03656
25.4888
14.9961
15.3809
27.3555
29.4902
31.4236
16.888s
18.7034
20.4420
0.03391
0.03182
0.03014
0.02877
0.02763
0.02667
0.02586
0.02516
0.02456
0.02405
0.02360
0.02320
20.7069
24.9986
33.1748
34.7609
36.r97 5
37.4986
38.6771
39.7445
40.7113
4 r .5869
42.3800
43.0984
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12.62t1
13.02-s
22.105'7
23.6961
25.2147
26.6632
28.0434
29.3572
30.6064
31.7929
32.9189
33.9863
653
i = 3.0C'Z
n
I
2
3
;l
5
6
7
8
9
t0
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12
13
t4
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16
17
18
19
2$
1.7535
t .u061
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i.8603
FlPi,n
i.0:100
1.0609
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i . 1255
i l-'.l93
i i941
t
2299
i.:668
1.3048
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1.3842
i.4258
i.4685
i.5126
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1.6u47
1.6528
I.7024
l9lril
22
23
36
0328
0()39
t .97
21
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26
27
28
29
2.r566
2.3566
30
2.4213
35
2.8 139
36
2.8983
2.2213
2.28i9
40
3.2624
45
3;816
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50
s-s
a.i)El1
60
65
5.89
l6
6.8_100
70
7.9118
75
9.t789
80
10.6409
12.3357
85
90
4.3005
95
t6.5782
r00
19.2186
PA-i,n F/Ai,n
0.9709 1.0000
0.9426 2.0300
{}.9151 3.0909
0.8885
i836
0.86:6 s.3091
0.8-175 6.468.1
0.8111 .6625
0.7891 8.8923
0.'7664 10.1591
0.7441 1t.4639
0.7224 12.8078
0.7014 14.1920
0.68i0 15.6178
0.661 I
17.0863
0.6419 18.5989
0.6.132 2ti.1569
0.6050 2t.1616
0.,s87.1 23.4144
0.-5703 25.t 169
0.-5537 26.8704
t).5-175 28.6765
0 5219 30.5368
0.5067 32.4529
0..1919 31.4265
0.4i7 6
36.4593
0.4637 38.5530
0.4s02 40.7096
0.4371 12.9309
0.4213 4s.2189
0.4120 41 .57 54
0.3554 60.4621
0.3450 63.2759
0.3066 s.4013
Q.2644 92.7199
o.22gt tt2.'7969
0. t968
136.0716
0.t697 163.0534
0.1464 194.3328
0.1263 230.5911
0.1089 272.6309
0.0940 321.3630
0.081 1
377.8570
0.0699 443.3489
0.0603 519.2720
0.0s20 607.2877
"1.
A./Fi,n
i 00000
A./Pi,n
i.03000
c.19261 0 52261
r,: -12353 L).35353
(',.23903 0.26903
1) 18835 0218.15
(,.15460 0.19460
0.r3051 0.16051
0.fi246 0.14246
0.09843 0.12843
0.08723 0.11723
0.07808 0.10808
0.07046 0.100.16
0.06403 0.09403
0.05853 0.08853
4.c5377 0.08377
C.r;J961
0.0+595
0c
+171
0.0-1981
0.07961
0.07595
a.0i271
0.03122
0.0598 1
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3.187
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0.C6487
0.f
0.4327
0.0-1081
c..J2905
0.\)2743
0.02594
0.02456
0.02329
0.0221t
0.021 02
0.01654
0.01580
0.01326
0.0 r 079
0.00887
0.00735
0.00613
0.00515
0.00434
0.00367
0.00311
0.00265
0.00226
0.00193
0.00165
0.[\6215
0.06081
0.05905
0.05743
0.05594
0.05456
0.05329
0.05211
0.0s I 02
0.04654
0.04580
0.01326
0.04079
0.03887
P/Ai,n A./Gi,n
0.9709
n/a
1.9135 0.4926
2.8286 0.9803
3.7111 1.4631
4.5797 1.9409
s.4172 2.4138
6.2303 2.8819
7.0197 3.3450
7.7861 3.8032
8.5302 4.2565
9.2s26 4.7049
9.9540 5.148s
10.6350 5.s872
11.2961 6.0210
t 1.9379 6.4500
[.5611 6.8742
13.1661 t=.2936
13.7535 r-3081
1.t.32-t8 8.1179
14.87'/5 E.5229
l 5.41 50
8.9231
r5.9369 9.3186
r 6.1.136 9.7093
16.9355 10.0954
17 .4131 10.4768
r'7.8768 10.8535
18.3270 t1.22ss
t8.764t i 1.5930
19.1885 11.9-558
19.6004 12.3t11
21.4872 14.0375
2t.8323 14.3688
23.1148 15.6502
24.5187 t7.1ss6
25.7298 18.5575
0.036r3
261744
27 .6't s6
21
0.03515
0.03434
0.03367
29.70t8
23.214s
24.1634
0.03735
0.0331I
0.0326s
0.03226
0.03 t 93
0.03 r 6s
28.4529
29.1234
19.8600
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22.t841
30.2008 25.0353
30.6312 25.8319
31.0024 26.5667
31.3227 27.23s1
31.5989 27 .8414
654
i = 4.00Vo
n
F/Pi,n
1.0400
1.0816
t.1249
1.1699
1.2t67
6
7
8
9
10
1.2653
1.31 59
1.3686
1.4233
1.4802
11
12
13
t4
15
t6
t1
18
t9
20
1.5395
1.6010
1.665 I
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E 11.7579
9 _'.u.6610
l0 28.9255
11 40.4957
t2 56.6939
13 '79.3i 15
14 1t 1.1201
I5 1_s5.5681
16 Zt-i.i953
Li l()4.9135
l8 .tro.37i{9
19 -i!1.6304
20 b-r6.6826
l1 r l7 r.3556
22 r5i9.8978
13 2295.8569
21 3214.1997
25 4199.8796
..r .
P/Fi,n F/Ai,n
0.7143 1.0000
0.5102 2.4000
0.3644 4.3600
4.2603 7. r 040
0. l 859
10.9456
0.1 328
16.3238
0.0949 23.8534
0.0678 34.3947
0.0484 49.1s26
0.0346 69.8t37
0.0247 98;7391
0.0176 139.2348
0.0126 195.9287
0.0090 275.3002
0.0064 386.4202
0.00.16 541.9883
0.0033 159.7837
0.0023 1t)6,1.6971
0.00 I 7
t49t .57 60
0.0012 2a89.2064
0.0009 292s.8889
0.0006 4097.2445
0.0004 s737.1423
0.0003 8032.9993
0.0002
11247 .1990
A/Fi,n
A/Pi,n
1.00000 L40000
0.41667 0.8 r667
0.22936 0.62936
0.14077 0.54011
0.09136 0.19136
0.06126 0.46126
0.04192 0.14192
0.02907 0.4290'1
0.02034 0.42034
0.0t432
0.41432
0.01013
0.00718
0.00510
0.00363
0.00259
0.00185
0.00112
0.00094
0.00067
0.00048
0.00034
0.00024
0.00017
0.00012
0.00009
0.4r013
0.40718
0.40510
0.40363
0.40259
0.40185
0.40132
0.40094
0.40067
0.40048
0.40034
0.40024
0.40017
0.40012
0.40009
P/Ai,n A/Gi,n
0.7143
rla
1.2245 0.416',7
1.5889 0.7798
1.8492 1.0923
2.0352 1.3580
2. I 680
1.58 I I
2.2628 t.7664
2.3306 1.9185
2.3790 2.0422
2.4136 2.1419
2.4383 2.2215
2.4559 2.2845
2.4685 2.3341
2.4775 2.3729
2.4839 2.4030
2.4885 '.2.4262
2.4918 2,4441
2.4941 "
2.4577
2.4958 2.4682
2.4970 2.476r
2.4979 2.4821
2.4985 2.4866
2.4989 2.4900
2.4992 2.4925
2.4994 2.4914
i = 50.007a
n
F/Pi,n
I
L5000
2
2.2s00
3
3.3750
4
s.0625
5
7.5938
6 I 1.3906
7 17.0859
8 25.6289
I
38..+-1-14
r0
,57.6650
Ir
86.4976
t2 129.7163
l3 t 9-1.6195
I;l 2919293
t5 437.8939
t6 656.8408
t7 985.26t3
18 t417.8919
19 2216.8318
20 3325.2561
P/Fi,n F/Ai,n
0.666'7 1.0000
0.4444 2.5000
0.2963 4.7500
0.19'75 8.r250
0.1317 13. I 875
0.0878 20.7813
0.0585 32.t719
0.0390 49.2s78
0.0260 i 1.8867
0.0173 1i3.3-101
0.0116 170.99s1
0.40i1 257.4927
0.00-s l
381 .2390
0.0034 581.8585
0.0023 873.7878
0.0015 1311.68r7
0.0010 1968.522s
0.0007 29s3:t838
0.0005 4431 .67 56
0.0003 6648.5 r 3s
A./Fi,n
A./Pi,n
r.00000
0.40000
r.50000
0.90000
0.71053
0.62308
0.57583
0.21053
0. 1 2308
0.07583
0.04812
0.54812
0.03108
0.53 108
0.02030
0.52030
0.5 r335
0.50882
0.0 r 335
0.00882
0.00585
0.00388
0.00258
0.00172
0.00114
0.50585
0.-s0388
0.502s8
o.50172
0.501t4
0.00076
0.00051
0.50076
0.00034
0.s0034
0.50023
0.50015
0.00023
0.0001 5
0.5005
P/Ai,n
0.6667
l.llrl
1.4074
1.6049
1.7366
.8244
8829
9220
9480
9653
1.9769
1.9846
t.9897
1.9931
1.9954
1.9970
1.9980
1.e986
t .9991
1.9994
A/Gi,n
nla
0.4000
0.7368
I .0154
1.2417
1.4226
r.5648
1.6752
1.1596
1.8235
r.87r3
r
.9068
t.9329
r.9519
t.9657
1.9756
1.9827
1.9878
1.9914
1.9940
668
i = 70.00Va
F/Pi,n
1.7000
)
3
4
5
6
7
8
9
10
2.8900
4.9130
8.3521
1 986
14.
24.t376
4 t .0339
69.7576
r 18.5879
201.5994
11 342.7 t90
12 582.6222
13 990.4578
t4 1683.7783
15 2862.4231
P/Fi,n F/Ai,n
0.5882 1.0000
0.3460 2.7000
0.2035 5.5900
0.1197 10.5030
0.0704 18.855
0.0414 33.0537
0.0244 57.t912
0.0143 98.22s1
0.0084 16't.982'7
0.0050 286.5706
0.0029 488.1699
0.0017 830.8889
1
0.0010 1413.51I I
0.0006 2403.9690
0.0003 4087.7472
A./T.i,n
A/Pi,n
r.00000
0.37037
1.70000
1.07037
0. I 7889
0.87889
0.79521
0.75304
0.09521
0.05304
0.03025
0.01749
0.01018
0.00595
0.00349
0.73025
0.7 t7 49
0.71018
0.70595
0.70349
0.00205
0.00120
0.7020s
0.70120
0.70071
0.70042
0.70024
0.00071
0.00042
0.00024
P/Ai,n .
0.5882
0.9343
1.1378
1.2575
1.3280
1.3694
1.3938
I .4081
t.4165
1.4215
1.4244
t.4261
t.4271
1.4277
1.4281
A/Gi,n
nla
0.3704
0.6619
0.8845
t.0497
I . 1693
1.2537
1
.3122
1.3520
1.3787
1.3964
1.4079
1.4154
1.4203
1.4233
i = 90.0A7o
n
F/Pi,n
I
1.900
2
3.610
3
6.859
4
13.032
5
24.761
6
47.046
7
89.387
8 169.836
9 322.688
10 6l 3.107
11 I164.903
12 22t3.31s
13 4205.298
t4 7990.06',7
15 l5l8l.l27
P/Fi,n F/Ai,n
0.5263 1.0000
0.2770 2.9000
0.1458 6.5100
0.0767 13.3690
0.0404 26.40t1
0.0213 51.162t
0.0112 98.2080
0.0059 187.5951
0.0031 357.4308
0.00 16
680. I I 85
0.0009 1293.2251
0.0005 2158.1277
0.0002 4671.4426
0.0001 8876.1410
0.0001
6866.8078
A,/Fi,N
A,/Pi,N
1.00000
1.90000
0.34483
1.24483
0.15361
1.05361
0.07480
0.03788
0.97480
0.93788
0.01955
0.91955
0.01018
0.91
0.00533
0.90533
0.00280
0.90280
0.00147
0.90t47
0.00017
0.90077
0.00041
0.0002 r
0.000 r r
0.90041
0.90021
0.00006
0l
0.9001r
0.90006
P/Ai,n
0.5263
0.8033
0.9491
1.0259
1.0662
1.0875
I .0987
l. r 046
t .107'7
r.1093
1.1102
l.l 106
1.r108
r.1ll0
l.t It0
A./Gi,n
nla
0.34.18
0.5991
0.778'7
0.9007
0.9808
1
.03
l9
1.0637
1.083 I
1.0948
1.totl
L l0-57
t.1080
1.1094
L1101
i = ll0.00Vo
n
1
2
3
4
5
-10.841
,35.766
7
8
180.109
9
10
11
t2
F/Pi,n
2.100
4.410
9.261
t9.118
378.229
794.280
r 667.988
3s02.775
7355.828
P/Fi,n F/Ai,n
0.4762 1.0000
0.2268 3.1000
0. t 080
7.5 I 00
0.05 r4
16.77 t0
0.0215 36.2191
0.01 l7
71.0601
0.0056 162.8262
0.0026 342.9351
0.001 3
721 .1637
0.0006 |st5.4437
0.0003 3183.4318
0.0001 6686.2068
A./Fi,n
A/?i,n
1.00000
2.
0.32258
0.13316
0.05963
r.15963
r0000
1.12258
.233
l6
0.0276r
t.t276t
0.0r 298
0.006 r4
l.l
1.10614
0.00292
1.10292
t298
0.00139
l.l0l39
0.00066
r.1 0066
0.0003 r
0.000 r 5
l.t003l
1.10015
P/Ai,n A/Gi,n
0.4762
nla
0.'7029 0.3226
0.8109 0.-5459
0.8623 0.6923
0.8868 0.7836
0.8985 0.8383
0.9040 0.8700
0.9067 0.8879
0.9079 0.8977
0.9085 0.9031
0.9088 0.9059
0.9090 0.9075
i=
n
I
2
3
4
5
6
7
8
9
r0
F/?i,n
2.300
s.:ro
lt
i67
:;.qi4
6i.i/:3
148.tI6
3-10..i.{3
783.1
l0
1801.i53
4142.651
l1
9528.0e8
12
2t914.6)4
130.007o
P/Ti,n F/Ai.n
0..13478 I 0000
0.18904 -3.3000
0.08219 I5900
0.0t573 2A 7510
0.u1554 +Y.i4t1
0.00676 '.261.14()4
I 13.1045
4.00294
0.00128 601.6230
0.00056
0.00024
669
A./Fi,n
A./Pi,n
p/Ai,n
A"/Gi,n
00000
2.30000
c.30-103
u.1 16-11
0.0-18I 8
1.60-103
1.4164t
0.0:c-52
t._12052
0.43'18 nJa
0.5238 0.3030
0.7060 0.5006
0.1417 0.6210
0.7i73 0.6903
0.00884
0.00383
0.00166
0.00072
1.308E4
0.76-10
1.3.18 i 8
l.30383
1.30166
1384.7328
3185.8855
0.00031
l .30031
0.0rJ010 7328.5366
0.00005 16856.6342
0.00014
0.00006
1.30014
1.30006
r.30072
a]670
0 7682
0.7688
0.7690
a.1692
0.7692
0.77'81
0.7486
0.7590
0.7642
01668
0.7681
0.7687
i = 150.007o
n
1
2
3
rt
5
6
7
ti
9
0
l'/Pi,n
2.500
6.250
15.6t5
-39.J63
97.656
2+1.1+1
rrl0.i-:2
1525.879
3814.697
9536.713
1l
2384 r .858
t2
s9601.64s
P/Fi,n F/Ai,n
u..10000 i.0000
0.16000 3.5000
0.06400 9.7500
0.02-<60 25.37 50
0.0 l 024
61 .137 5
0.004 0
162.0938
0.00 r 64
406.2311
0.00004
0.00002
F/Pi.n
1.000
9.000
27.000
81.000
243.000
729.000
2t87.000
650 1.000
19683 000
590.19.000
0.
1.78571
1ii256
,.60256
0.039+
0.00246
\.50216
1016.5859
0.00098
2542.4648
6351.1621
0.00039
0.00016
r.50098
r.50039
15893.9053
0.00006
39735.7632
0.00003
0.00002
2.50000
0.006 r7
P/Fi.n F/Ai.n
0.33333 r.0000
0.1 il il
4.0000
0.03704 13.0000
0.0 23s
40.0000
0.00412 t21.0000
0.001 37
364.0000
0.00046 1093.0000
0.000 5
3280.0000
0.00005
1.00000
0.:s5?
.53941
1.51552
i=
n
I
2
3
4
5
6
7
8
9
10
A./Pi,N
0.01552
0.00066
0.00026
0.00010
A/Fi.n
.50617
r.500r6
1.50006
1.50003
P/Ai.n .d'Gi,n
0.4C00 nla
a.55ii0 0.2i57
0 5240 0.46 15
a.6$6 0.56i6
0.6598 0.6149
0.66-19 0.6420
0.66-s6 0.6552
a.6662 0.6614
0.6665 0.6613
0.6666 0.6656
0.6666 0.6662
0.6667 0.666s
200.A0Vo
ArTi,n
:!/Pi.n
1.00000
3.00000
2.25000
2.07692
2.42500
2.00826
0.25000
0.07692
0.02500
0.00826
0.00275
0.00091
c.00030
984r.0000
0.000 r0
2952.1.0000
0.00003
I
2.00275
2.0009r
2.00030
2.00010
2.00003
P/Ai.n
0.3333
0.4444
0.48 r 5
0.4938
0.4979
0.4993
0.4998
0.4999
0.s000
0.5000
A/Gi,n
nla
0.2500
0.3846
0.4500
0.4'793
0.4918
0.4968
0.4988
0.499s
0A998
APPENDIX B
elt+at-plt=prAt
or
plt+4t--plt
At
-r.
B-1
,.rn
plt+at-plt=dp=p.
A^t-+O At
dt
since the left side of Equation B-2 is the definition of the derivative
with respect to t.
B-2
of p
671
t?F
oo
J 7:
,n=P
i:
iP
'=,.n
B-3
Jrdt
t=0
ln
in P,*-. 1l
or ln F/P=rn
lo
B-4
F=Pern
=p(pn\' ,,n/
B-5
r = r'(i.
r(nlrr,,
B-6
"'n )
)
The factor l/ern is the continuous interest single payment present worth
i rct<.rr.
F=A+Aer+ Ae}t+...+A".(n-2)*o.r(n-l)
B_7
Fer=Aer
+Ae2r+Ae3r+...+o.r(n-l)+Aem
B_g
Fer-F=Aern-A
or
, = o[{.-L-l= o(r7o..,)
\
L.'-t
-l
B-9
where the factor (ern - \ I (er - 1) is the continuous interest discrete end-ofperiod payment uniform series compound amount factor.
a=
ri:l-r
L.'n -
J=.(or,.,)
B-ro
_l
t*
"*ll l=o(rlo.,n)
L(" -')"* l
p=nl ,
,_,,
where (em
1)/(er l)srn is the continuous interest discrete end-of-period
payment uniform series present worth factor. Rearranging
Equation B_11
gives
[f". - r)"- I
o=tl*l=n(er,,,)
L_l
w
B-T2
-l
8.2 Applications
EXAMPLE B-1 Continuous lnterest Compared to Annual
I
and Effective lnterest.
Calculate the future worth 6 years from now of a present sum of
$1000 if interest is:
a) 10% per year compounded continuously
b) 10% per year compounded annually
c) an effective annual rate for 10% compounded corntinuously.
Solution:
$1ooo
a)
1____6
F=1000(F/prr,6) forr=0.10
1772
a)
$t0,000 A
A
0
1----6
-1
.fi70
soA=.10,0C0(fupr,1O)=$1gZO
e.6011..60
- r,'t -
(o o0l e-[l'ezzt)
0.8221
.1359
b) A = 10,000 (tuPi,1g) = $1359
,,r,,
continuously gives
the same total annual interest as compounding the effective rate, E
=
er - l,annually.
continuous Interest Factors for I-ump
FiP,.., - eril
P/Fr,n
= l/ern
F/Ar.,,
lstl)
- I )iter-
l)ernl1ern
1;
Sr-rm
End-of-period payments:
674
r=
l0.00%o
F/Pr,n
P/Fr,n
F/Ar,n
A./Irrn
1.10517
0.90484
0.81873
1.00000
2.1C517
0.4'7502
3
4
1.22140
r.34986
1.49182
1.648't2
0.74082
3.32657
4.67643
6.16826
0.21384
0.16212
,,
1.82212
2.01375
2.22554
2.45960
6
7
l0
2.7t828
l1
3.00417
3.32012
3.66930
4.05520
4.48169
t2
13
t4
15
t6
0.67032
0.606s3
0.54881
0.49659
0.44933
0.40657
0.36788
0.33287
0.30119
0.272s3
0.24660
0.22313
7.81698
9.63910
l r.65285
16.33799
o.06t2l
19.05628
0.05248
0.04533
0.03940
0.03442
22.06044
25.380s6
29.A4986
33.10506
t9
7.38906
2t
8.16617
9.02501
9.97 418
1.0231 8
0.07427
0.06721
13 I .973 10
22
23
24
25
26
27
28
)o
12.18249
13.46374
14.87973
16.44465
I 8.1 741 5
30
20.0855,1
35
40
45
50
55
60
65
33.1 1545
-54.59815
90.01 7 l3
r48.41316
244.69193
403.428't9
665.t4163
0. 1 8268
0.12793
0.t0374
0.08582
0.07205
20
r8
0.20190
0.30061
13.87839
4.95303
5.47395
6.04965
6.68s89
17
1.00000
37.58674
42.53978
48.01372
0.03021
0.0266r
A./Prrn . P/Ar,n
1.10517 0.90484
0.58019 1.72357
0.40578 2.46439
0.31901 3.1347 I
0.26729 3.74124
0.23310 4.29005
0.20892 4.78663
0.19099 5.23s96
0.17723 5.64253
0.16638 6.01041
0.15765 6.34328
0.15050 6.6M48
0.14457' 6.91701
0.t39s9 7.16361
0.13538 7.38674
0.13178 7.58863
0;t2868 7.77132
0.12600 7.93662
0.t2367 8.08618
54.06337
60.74927
0.02351
0.02083
0.01850
0.01646
0.t2246
68. l 3832
0.01468
0.1 1080
76.30449
0.0131 I
0.r0026
85.3295 I
0.01t72
0.09072
0.08208
95.30369
106.32686
0.01049
0.00940
I18.50936
0.00844
0.007s8
0.1127
8.86932
146.85283
163.29747
0.00681
0.
8.9301 3
181.11162
0.005-s
305.36438
509.62900
846.40443
0.0032"7
0.16530
0.14957
0.13534
0.06081
0.05502
0.04979
0.03020
0.01832
0.011 l1
0.00674
0.00409
0.00248
0.00150
1401.65325
0.00612
r
0.00196
0.001 r 8
0.00071
23r7.10378
0.000.13
3826.42655
6314.87910
0.00026
0.00016
0.12t63
8.22152
0.11985 8.34398
0.11828 8.45478
0.11689 8.55504
0.11566 8.64576
0.11458 8.'12'.784
0.11361 8.80211
1
5
198
0.11129 8.98515
0.11068 9.03194
0.10845 9.2212t
0.10713 9.33418
0.10635 9.40270
0.10588 9.44427
0.10560 9.46947
0.10543 9.48176
0.10533 9.49104
r=
675
12.(){lc,t
A/?r,n
t.127 50
F/Pr,n
P/Fr,n
F/Ar,n
A./Fr,n
t.12i 50
2. i :750
3._1'9875
1.00000
0.4700.1
3
4
1.2'7125
l.+J-1 1-)
1.61607
0.88692
0.78663
0.69768
0.61878
1.00000
8-r208
0.29423
0.20695
1.82212
0.548I-t
6.44815
0.155rJii
0.282-58
).05443
0.486r5
8.?10?.1
0.1
1.3 i 637
0.43 i
0.3t470
2092
0.09686
0.24E41
0.22435
0.20660
0.19306
0.18245
0.17397
0.16708
0.16142
4.02557
4.45728
4.84018
0.149"10
6.69344
6.82347
6.93880
7.04108
7.13180
:
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'2.61170
9
10
2.94468
3.32012
11
,+
7l
0.38289
0.33960
t2.64107
0.079 r r
15.252',71
0.301 19
I 8.1974-1
0.06556
0.054!,5
?.74342
4.22070
4.75882
0.26714
0.23693
0.210r 4
21.517 -\6
5.36556
0. I 8637
34.24050
15
6.04965
0.165i0
39.50606
0.01647
0.03959
0.03392
0.02921
0.02525
l6
b.82096
0.14461
45.65570
0.02r 90
t7
7.69061
rt4
52.4'7666
0.01906
ts
0. 130,13
0. l 1533
60.i6127
4.0rc62
9.7'1668
I 1.02318
0.10228
0.09072
68.83841
0.014-53
78.61509
0.01272
0.08046
0.07136
0.06329
89.63827
102.06586
I 16.0E007
0.00e80
0.0561
l5
12.428b0
14.01310
15.79984
17.8142't
20.08554
4.04919
t49.69418
0.007s8
0.00668
:6
22.64638
25.53372
28.'789t9
0.04416
t69.179'.72
0.005E9
0.039 r 6
0.034'71
0.0308 r
0.02'732
192.426t0
2t7.95982
0.00520
0.00459
0.0040s
0.00358
0.01500
0.00823
515.19963
0.004s2
1728.72046
50
55
221.40642
40?.42879
0.00248
73i.09519
0.00 r 36
t)0
6-.
l i39.4_1076
2440.60197
ti
l3
l4
is
20
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-))
:rt
21
)7
28
29
8.67
32.45972
30
36.59823
35
.{0
121.5t042
tl5
66.68633
25 750e3
29.48 r 68
31 .87991
246.74901
219.20873
945.20309
1 56.38220
5757.75150
0.(i00r5
10497.7-55+1
0.00041
19134.60561
0.01I t6
0.00861
0.00194
0.00106
0.00058
0.00032
0.00017
0.00010
0.00005
0.59753
0.12112
0.33445
0.r5670
0.t52-t5
0.14655
a.i44t2
0.14202
0.14022
0. 13865
0.t3729
0.13611
0. I 3508
0.13418
0.13339
0.13269
0.13208
0. l3 l s5
0.13108
0.12944
0. 128-55
P/Ar,n
0.88692
1.67355
237122
2.99001
3.53882
5.17977
5.48097
5.74810
s.98503
6.19516
6.38154
6.54684
.21226
7.28362
7.14691
7.40305
7.15283
.49699
7.53616
7.57089
1 .60170
7.62902
7
'1.72572
7
.77878
2808 7.80791
0.1218t 7.82389
0.12"767 7.83266
0.t2ii9 7.ri3748
0. r
0.1275s
7.84012
676
r=
F/Pr,n
P/Fr,n
l5.00%a
F/Ar,n
A./Fr,n A./Pr,n
P/Ar,n
17.28778
20.08554
0.09072
0.07808
0.06721
0.05784
100.64484
0.M979
1t7.93262
2t
2333606
0.04285
22
23
24
27.11264
0.03688
.50039
0.03175
0.02732
0.02352
r38.01816
161.35423
l 88.46686
219.96726
256.56549
299.086s7
348.48902
405.88648
472.57281
ss0.05 r 27
0.00334
0.00287
0.00246
0.00212
0.00182
0.0052s 1171.36068
0.00248 2486.672.70
0.00117 s27t.18827
0.00085
0.00040
0.00019
0.00009
0.00004
0.00002
0.00001
1.16183
0.86071
1.00000
2
3
4
7.34986
0.74082
0.63763
2.16183
3.51169
6
7
8
9
10
11
12
13
t4
1.56831
1.82212
2.11700
0.54881
5.08001
0.47237
6.90212
2.4s960
2.85765
3.32012
3.85743
4.48169
4.40657
0.34994
0.30119
0.25924
0.22313
11.47873
14.33638
17.65650
21.51392
s.20698
6.44965
7.02869
0.19205
0.16530
0.14227
0.12246
0.10540
8.t661't
15
9.48774
16
17
18
I 1.023 18
I9
20
t2.80710
14.87973
31
,(
36.59823
42.s2108
26
27
28
29
49.40245
57.39746
30
66.68633
0.02024
0.01742
0.01500
77.47846
0.0t29t
90.01 71 3
0.0r 111
35
190.56627
40
403.42879
854.05876
45
50
55
60
6s
1808.04241
3827.62582
8 r 03.08392
17154.22878
9.01912
2s.99561
31.20259
37.25224
44.28092
52.44709
61.93483
72.95801
85.76511
0.00055 11166.00777
0.00026 23645.34077
0.00012 s0064.08891
0.00006
10s992.s'7917
0.16518
0.16470
0.16430
0.16395
0.16365
0.16269
0J6224
0.t6202
0.16192
0.16188
0.16185
0.16184
6.05408
6.07 i 5 1
6.08650
6.0994r
6.11052
6.14674
6.16385
6.17193
6.t7574
6.17755
6.17840
6.17880
r=
n
I
2
J
4
5
F/Prrn P/Tr,n
t.22140 0.81873
t.49182 0.67032
1.822t2 0.5.18S1
1.22554 0.449i3
2.7 I 828 0.36788
20.0(lVo
A./Fr,n , A/Pr,n
P/Ar,n
0.81873
5.5353-5
1.00000 1.22140
7 0.67157
t).26931 0.49071
u.180r'i6 0.10206
7.76089
0.
F/Ar,n
1.00000
2.22140
3.1i323
3.32012
4.05520
4.95303
6.04965
7.38906
0.30119
0.24660
0.20190
0.16530
0.13534
0.1 1080
36.24622
0.09072
45.27t24
l5
9.02501
18
t3.46374
i6.14465
20.08554
l6
24.53253
0.04076
6
7
8
9
10
11
t)
r3
l4
17
r8
l9
?{)
21
22
23
21
l5
l 1 .023
10.41917
13.79929
t7.85449
22.80752
28.85717
0.0742'7
0.06081
56.294.1"
69.758 l5
86.20280
0.049i9
0.0223'7
06 28833
30.E2086
l 60.78496
197.38320
0.01832
242.08438
0.0rs00
296.68253
363.36886
29964t0 0.03i3 /
36.59823
41.74118
s4.59815
66.68633
8r.45087
99j8432
l-18.11 316
121.5t442
26
27
28
29
30
t81.27224
221.10642
270.12611
330.29956
403.42879
-15
40
r096.63316
2980.9-5798
45
50
22026.16576
8103
08392
0.02732
0.01228
144.819'73
541.30405
665.8 I 447
0.01l'J05
0.01)823
0.0067-l
0 00ss2
0.00,1.s2
8t4.22762
995.499E7
12 l 6.90628
0.00370
0.00303
0.00248
t487.33269
1811.63225
4948.59160
0.00091
0.00034
0.00012
36591.32242
0.00005
9948t.44253
677
3459.44381
0.4501
i28,i5
1s025
0.095.13 0.31683
1.48905
2.03.1\6
2.48i
19
2.8s507
3.15627
678
r = 25.00Vo
n
F/Pr,n
F/Ar'n
P/Fr,n
1.28403 0.77880
1.648'12 0.60653
2.1
4
3
6
7
9
10
1700
2.71828
3.49034
4.48169
5.15460
7.38906
9.4877 4
12j8249
0.47237
0.36788
0.28650
0.22313
0.17377
0.13534
0.10540
0.08208
13
15.64263 0.06393
20.08554 0.u979
25.79034 0.03877
t4
33.1
11
t2
15
t6
l7
18
19
20
2t
1545
12.25837
L6.74006
22.49466
29.88312
39.37146
51.55395
67.19658
87.28212
113.0'1246
0.02352
146.18791
54.59815 0.01832
70.10541 0.01426
90.01713 0.011 I
115.58428 0.00865
148.41316 0.c0674
l 88.70899
243.30714
313.41255
403.42969
519.0139'l
190.56627
244.69193
21
24
25
3 14.1
26
27
28
29
30
665.14 163
854.05876
9066
403.42879
s 18.01282
r096.63316
1408.10485
I 808.0424 I
35
6310.68810
40
22A26.46s'76
"168'79.91962
50
8.76803
0.03020
42.52108
'r",
't5
1.00000
2.28403
3.93275
6.04915
268337.28595
0.00525 667.42713
0.00409 851.99340
0.00318 I 102.68533
0.00248 1416.87 599
1820.30478
0.001 93
0.00150 2338.31',761
3003.45924
0.001 17
0.00091 3857.51800
0.00071 49-s4.l5ll6
0.00055 6362.25600
0.00016 2221s.22316
0.00005 71541.51616
0.0000r 2706'76.19698
0.00000
944761.52569
A./Fr,n A./Pr,n
P/Ar,n
679
= 30.007o
F/Ar.n
F/Pr,n
P/Fr.n
1.34986
82:12
0.74()82
0,5-i881
2.,15960
0.40657
2.
,1. 1 71
3.32q I 2
0.301 I 9
0.223
6.63 i 58
9.t5 i ;0
3
4
5
'1.-18
6
7
1:,9
1.00000
ii9s6
lr
98
0.06928
0.04882
0.419
i4
0.1
6530
14.43319
8.r6617
0.1:246
20.48-?t)3
1.023
0.09072
0.06721
28.64920
39.67238
54.552t r
0.03.190
4.63765
01.75029
l 3E.34852
0.013,10 0.36326
0.00e83 0.359(t9
0.00713 0.3.57r)9
t8i.75097
0.0c5
t0
14.87913
20.08554
11
27.112{14
t2
36.598:3
r8
13
49.40245
t4
l5
66.68633
90.017 ,
r6
0.049;9
0.03688
0.02i 32
0.02024
0.0r 500
0.0iIr1
251.4311()
111.510-i2
.16.1.02191
i8
0.00823
0.00610
"165.96465
22r.40612
0.004-52
629.98676
19
2A
298.86740
403.42819
0.0(1335
85 1.393 17
0.00248
I 150.2ir057
2l
-54.1.57
l9l
22
73-5.09519
0.00184
0 00r36
2098.26128
3"14.45-i43
553.669-17
_-1
q92.27,41 I
34
1339.:13076
l-i
i 8i)8.0.12.11
0.00075
0.000-i5
)6
)7
2J:10.60197
0.000.11
6973. I 0436
0.00030
0.00022
94 I 3.70o1 3
l8
-119'1.468i)7
4J11 .066i 4
29
6002.91221
0.000 r 7
30
103.08392
0.00012
0.00 10 I
2833.35647
i82-s.631 t8
5165.061')-l
12708.17.140
17155.21114
23158.1s335
P/Ar,n
0..i:5i6
0.23.'69
0. i 5t)79
0. l0iia9
6.04965
t7
A/Fr.n A./Pr,n
0.02521
0.018-j3
0.39868
0.38476
0.37507
0.36E l
2.38582
2.5\)828
2.59900
2.66620
2.71599
0.0(13!)3
9
0.3-,l'9
2.75287
2.78020
2.80044
2.81543
2.82654
0.00190
0.0021 5
0.00159
0.00117
0.000s7
0.35216
0.352u0
0.351.15
0.35103
0.35073
2.83477
2.84087
2.84539
2.84873
2.85121
0.00064 0.350i0
0.00048 0.35034
0.(10035 0.3501I
0 00026 0.35012
().0c019 0.350')5
0.35u00
0.000 l4
(r 0001I 0.34991
0.00008 0.34991
0.00006 034992
0.00004 0.34990
2.85305
2.85441
r3
0.3551
2.855,12
2.856I6
2.856,-2
2.857 12
2.85'743
2.85'165
2.85782
2.85794
680
r=
n
F/Pr,n
P/Tr,n
1.49t82
2
3
2.22554
3.32012
4.95303
7.38906
0.67032
0.44933
4
5
6
7
8
9
t0
11
t2
13
t4
15
16
17
l8
t9
20
2t
r,
23
24
25
26
27
28
29
30
0.301
I9
0.20190
0. I 3534
40.00Vo
F/Ar,n
A.rFr,n
1.00000
1.00000
0.40131
2.49182
4.71737
8.03748
12.99051
11.02318
0.09072
16.44465
20.37957
0.06081
31.40275
47.84739
72.37992
24s32s3
36.59823
54.59815
81.45087
121.51042
181.27224
270.42641
403.428.79
601.84504
897.84729
1339.43076
1998.19589
2980.95798
4417.06674
6634.24400
9897.12904
14764.78t54
22Q26.46576
328s9.62s62
49020.801 05
73130.44170
t09097.79906
1627 54.79109
0.04076
0.02732
0.01832
0.01228
0.00823
0.00552
0.00370
0.00248
0.00166
0.0011r
0.00075
0.00050
0.00034
0.00022
0.0001s
0.00010
0.00007
0.00005
0.00003
0.00002
0.00001
0.00001
0.0c001
108.978
l6
163.5763r
245.02718
366.53759
547.8A984
818.23624
1221.66504
1823.51007
2721.35',736
4060.78813
6058.98402
9039.94200
13487.00874
20121.25274
30018.38 t 78
41783.t6333
66809.62908
99669.25470
r 48690.05575
221820.49714
3309 I 8.29650
0.21198
0.12442
0.07698
A./Prrn
P/Ar,n
t.49t82
0.67A32
0.893 l4
0.70381
0.61624
0.56880
0.04907
0.03184
0.02090
0.54089
0.52367
0.0r 382
0.00918
0.50564
0.50100
0.00611
0.49794
0.00408
0.00273
0.00183
0.00122
0.49591
0.49455
0.00082
0.00055
0.00037
0.00025
0.00017
0.00011
0.00007
0.00005
0.00003
0.00002
0.00001
0.00001
0.00001
0.00000
0.00000
0.5t272
l.l
196s
1.4208.1
r.62274
1.75808
L84879
1.90960
1.95037
1.977 69
1.99600
2.00828
2.01651
2.42203
0.4936s
2.O2s73
0.49305
2.02820
0.49264
2.02987
2.03098
2.03173
2.03223
2.03256
0.49237
0.49219
0.49207
0.49t99
0.49194
0.49190
0.49187
0.49186
2.0331|
0.491 8s
2.033 r 5
0.49184
0.49183
0.49183
0.49183
2.03318
2.03320
2.03322
2.03323
2.03323
0.491 83
2.03279
2.03294
2.03304
681
r = 50.007o
n
F/Pr,n
1.648,12
2.71828
4.48169
7.38-'ti,t6
6
7
n
9
l0
11
12
13
14
15
16
t'7
l8
19
20
"rl
22
23
24
8:-i9
20.0E554
33.11545
s.1.598 15
90.017 r 3
148.41316
244.69t93
4A3.42879
665.14163
1096.63316
1808.04241
2980.95798
4914.76883
8103.08392
13359.72681
22026.46s76
363 15.50261
59874. l4 r 60
98115.'77082
162754.79t09
l5
268337.28_s95
:6
_142.11
27
28
29
30
a-
12.
3.39 I r),+
729-1r 6.36s i
1202604.281 r2
19817-59.25868
3269011.361t9
Pllirrn
F/Ar,n
0.60553 1.00000
0.36788 2.61872
0 22i 13
-s.36700
0.135-34 9.8,1869
r; 08108
11 .23115
{, 0-1979
29.4207+
0.03020 49.50578
0.01832 32.62123
0.0i l i r
137.21938
0.00674 221.23651
0.00409 37 5.6496't
0.00248 620.34160
0.00150 1023.71a$
0.00091 1688.91203
0.00055 2785.545t9
0.00034 4593.58760
0.00020 7 571.54558
0.00012 12489.31441
0.00007 20592.39833
0.00005 31952.t2st4
0.00003 55978.59090
0.00002 92294.093s1
0.0000r 152168.23s I
1
0.00001 250884.005e3
0.0c000 413638.79702
().00000 681976.08297
0.00000 I 12.1389.47401
(,.00000 18538()-5.8.12t9
0.00000 30-s64 I 0.I 23.52
0.00000 .5039169.38220
A,/Fqn A/Pr,n
1.00000 1.64872
437',154 1.02626
tl. 18632 0.8350.1
0.10154 0.75026
0.05801 0.70673
P/Ar,n
0.606-53
0,9,1441
I . 19754
1.33288
t.11496
0.68271 1 16475
0.66892 1.19491
'J.66082 1.51326
0.65601
1.s2437
0.65312 1.53 I
0.00266 0.65138 1.53519
0.00161 c.65033 1.:3767
0.00098 0.64970 1.53918
0.00059 0.6493t 1.54009
0.00036 0.64908 t.54064
0.04Q22 0.64894 1.5,1098
0.00013 0.64885 1.s1t r8
0.c0008 0.64880 I .541 30
0.00005 Q.il81't r.54138
0.00003 0.64875 1.54t42
0.00002 0.64874 1.54115
0.00001 0.64873 1.54147
0.00001 0.64813 1.54148
0.00000 0.64813 I .541 ,18
0.00000 0.64872 1.5'11,19
0.00000
0.64812 1.5.1149
0.00000
0.618'72 1.54t49
0.00000
0.648'12 1.s4149
0.00000
0.61812 1.54149
0.00000
0.64872 1.54119
0.03399
0.02020
0.0r2r0
4.00729
0.00440
11
APPENDIX C
CONTINUOUS INTEREST,
CONTINUOUS FLOWING VALUE FACTORS
lump sums. Since the interest rate compounding must correspond to the
periods used, continuous interest must be used with the continuous flow of
funds, i.e., an infinite number of payment periods require an interest rate
with an infinite number of compounding periods.
The following symbols
will
interest rate
682
Rlr+at-Plt=PrAt+AAt
683
c-l
if.= pr+ A
di
'i'#='l?0,
P=P
m(rr+4ll=.1:
or
c-2
t=0
tn(rr
A)/(r,+ A) = *
c-3
SO
Fr+A
C-4
Pr+ A
When
-=eirrthere are no continuous uniform annual paymenis, A- 0 and p Pern, the same as Equation B-5 developed in Appendix B for continuous
interest with lump sum p:ivments. The present worth equation P = F (l/em)
is the slme as Equation 8-6.
The liiirr lactors lirr Fi.{r,nl AiFr.n: P,'Ar.n: and A/pr,,., all dift'er from
the factors developeti in Appendix B. These tactors result from the follow-
ing deveiopments:
1. To relate F and
C-4 yield
F=A[ern
' -/''r"
where (ern
ilcirr
ru ng
\/
/
\
alp/a
-tl/r=
/"r,n/I
')l ' '.\'
C-5
iug
a = pr//"rn
/\
t-
'
- 1)=
/ Fl'\'/Fr.rJ
\
c-6
where r/(ern
684
A=p,",nl(r r(n/r,,n)
c-7
".,)=
where rem/(l - em) is the funds flow capital recovery factor. Note
that it is
negative since (1 - ern) will always be negative for all real values of
r and n.
= A(r
- ",") f (,"^)
x(e/n.,,)
c-8
where (1 - ernylsm is the funds flow uniform series present worth factor.
Note that both A and P/4.,n are negative in Equation c-s ,o give a pori i""
present value, P. It is normal to switch I em to em I so that
funds flow
factors are always positive. This is done in the remainder of this text.
These factors based on the funds flow concept find relatively wide usage
by companies in making economic analyses of alternative investment possibilities. It is felt by many economic analysts that because receipts and disbursements flow somewhat continuously, that the funds flow assumption
is
better than the end-of-period payments assumption with discrete compound
interest. This is true in some cases, but in most practical evaluation
cases.
both lump sum payments and continuous receipts and disbursements are
in'olved. Therefore, using e,ither method alone gives some error and the
best result would come from a combination of the methods. computer programming gets complicatecl when funds flow and discrete payments
are
both considered in the same problem, so it is common for cornpanies
to use
one method or the orher, but not a combinarion of both. Typicai percent
differences that result between using the two methods are illustrated
bv the fol-
lowing examples.
C.2 Applications
EXAMPLE
c-l
68s
a) P=?
A='1000
A=1 000
1 -
so
h=10
6.00
tor
P= 1000(PlAylg)=$6000
where
P/Ay,1O=
(e1.0- t)l(".1
r=0.10
t)e1.0
= 1.7183/(0.1052)(2.718) = 6.00
b)
P=?
A=1000
1-
so
6.325
P= 1000(PlAy,1fi=$6325
where
c)
p/A
7,10
.0
= (e1
A=1 000
o=1 0
for
r=0.10
5.41?/o deviaiion
between resuits.
EXAMPLE C-2 Analysis lnvolving Both Lump Sum
and Funds Flow payments
Development of an investment project involves the following cash
outlays: three lump sum payments of 970,000 at time zero and at the
end of the first and second years, and uniform funds flow payments
of $50,000 during each of the first three years. Assume a nominal
annual continuous interest rate of 10% and calculate the present
\'.,o":h of a.,l cay,n.enis:
a) assuming the funds flow payments to be end-of-year payments
b) assuming the lump sum payments to be funds flow payments
during the prior year
c) properly combining both lump sum and funds flow calculations
as appropriate.
686
Solution:
J .-.--..-\--,
J _-\__,
J _&_..n
r = 10oh
a)
Present worth
where Pl
A1,2
1.720
:
.741
+ s0,000 (piFp,3)
r3rtgri120,o00(p/A1,2)
(s,2-
)/(s.1
flow.
plA1,2=e-2
110.1e.2 =
(2214)/0.12214= 1.g10
.952
.818
/F 12)
(p
c)
1.720
P.W. = 70,000 + 70,000(P/Ay,2) +
2.594
50,000(plAr,g) = $320,100
Note that a) and b) results both differ from c), with the correct
result, "c", between the results for "a" and "b".
C.3 Discount Factors to Tinre Zero for Single Funds Flow payments
To find the present worth of a funds flow single cash payment or receipt
nhich rve will call F*, made during the uth year as illustrated
I -F*-
P=?
t)1n-ln
()n tl)e diagram,
n*
(Pi
\1)
P,
e = (e7r;.n-r
)(n.)(rla,,
/_ \
=
(;,#jr)t#j
o.[#.J=.-(0,'.*,,n)
one,e P,'F*,.n
FIA':'r,n-1ern-l)/r
A'F''r.,r=r/(ern- l)
A/P'r'r,n
rern/(ern
P/A*r,n = (ern
P/F*r,n = (er
1)/rern = [(er
F/Pl'r.n = ((er
l)/rern = [(".n
1)/r][l/ern]
l)/r][l/ern]
1)/rl[er(n-l)1
688
*r = 10.00%o
n
F/P*rrn
P/F*r;n
F/A*r,n
A/F*r,n
A/P*r,n
1.05 171
r.05171
2.21403
3.49859
4.9t825
6.48721
0.95083
0.45167
0.28583
0.20332
0.154 r5
1.05083 0.9s163
0.55167 1.81269
0.38583 2.59182
0.30332 3.29680
0.25415 3.93469
0.22164 4.51188
0.19864 5.03415
0.18160 5.50671
0.16851 5.93430
0.15820 6.32121
0.14990 6.67129
0.14310 6.98806
0.13746 7.27468
0.13273 7.53403
0.12872 7.76870
0.12530 7.98103
0.12235 8.17316
0.11980 8.34701
o.tt7 59
8.50431
0.11565 8.&665
0.11395 8.77544
1.16232
0.95163
0.86107
3
4
1.28456
1.41966
0.70498
1.56897
0.63'789
1.73398
1.91634
0.577
2.tt788
9
10
2.34062
2.s8679
11
2.85884
0.779t3
8.221t9
0.12164
0.52226
0.47256
0.42759
0.38690
10.13753 0.0989
12.25541 0.08160
14.59603 0.06851
1'7.18282 0.05820
0.3s008
0.31677
0.28662
0.25935
0.23467
20.04166
23.20117
26.69297
30.55200
34.8r689
0.04990
0.04310
0.03746
0.a3273
0.028'72
5.209t5
0.21234
0.19213'
s.7 5700
0.1 7385
20
6.36247
7.03162
0.14233
39.s3032
44.73947
50.49647
56.85894
63.890s6
0.02s30
0.02235
0.01980
0.01759
0.01s65
2t
71.66170
80.25013
89.74182
100.23176
0.0t246
t2
13
3.15951
t4
l5
3.49180
3.8s903
4.26489
16
4.71343
t7
18
t9
22
23
24
25
0.r5730
tt4
0.12879
8.58844
9.49169
10.48994
0.1 1653
0.09541
I 1.59318
0.08633
.77
0.10544
llt.82494
124.63'738
0.01395
0.01114
0.00998
0.00894
12.8t244
0.07811
14.15994
0.07068
0.06395
0.05787
0.05236
t38.79732
154.44611
11t.74115
190.85537
0.00802
0.00720
0.00647
0.00582
0.00524
0.03176
0.01926
32r.1s452
0.0031 I
535.98
0.00187
26
27
28
29
17.29499
30
19.fi392
35
40
5r
45
50
t9
15.64915
31.51352
.95701
85.66263
141.23379
0.0t 168
0.00709
150
890.17131
1474.131s9
0.001l2
0.00068
0.t1246
0.lll14
P/A*En
8.89197
8.99741
0.10998 9.09282
0.10894 9.17915
0.10802 9.25726
0.10"t20 9.32794
0.10647 9.39190
0. 10582 9.44977
0.10524 9.s0213
0.103r
9.69803
0.10187 9.81684
0.101 12
9.88891
0.10068 9.93262
589
*r = l2.OVVc
n
F/Ptr.n
P/F*r.n
F/A*r,n
2.lir0-1 I
3.61 iC8
,5.
6.85(
1.06247
1.19194
3
4
1.3-s(){i7
1522t7
0.94233
0.81577
0.'14126
0.65; -i:l
.;
1.7 I t-04
0.5tt-:
2. I 8278
E.78oql
10.969i 2
1.461i18
9
10
2.71+s6
3.12864
0.517 i6
0.45:-i68
0.4068 r
0.3608 I
0.32001
tl
93-195
t.06247
i0
3i
,)5
i9
13.43080
16.20566
19.33431
1.52: 54
0.283E2
i2
22.86r.S.1
3.91'719
a.25i73
26.83913
13
4.48438
0.22326
31.3235t
14
15
055l2
5.70ttr6
0. 198Ct2
0. 17,5ri3
36.37963
.12.080r0
I6
6.42159
0.
17
7.24i')9
18
8.1 7 107
55;7
i9
9.2t236
20
10.387.r7
0.13815
0.12253
0. 1 0867
0.09639
48.50',1,:19
5-s.75508
63.92o l5
73. 139r)(r
83.52617
2t
I 1.7 r 184
0.085.19
95.23r1I
12
13.20506
108.,1-1:]36
23
0.07582
0.067:5
;t1t
25
4.888b6
t23.33)02
t6.18692
r8.9:720
0.059i.,-1
l+0.1iu94
0.052,)0
159.046 I 4
26
27
28
29
30
21.34036
0.04692
24.061
r8
0.0.11 6 I
1 80.38650
204.44768
27.12891
30.58776
34.48760
0.0369r
0.03273
0.02903
35
40
45
50
62.8405 r
I 14.50287
0.01593
0.00874
0.00480
0.00263
208.63784
380. 1629-l
7.24976
0.0
.5'17
.66281
97
0.01 050
197
0. r 3050
0.00922 0.12922
0.00s11 0.128ll
0.0c7 i 4
0. i2i 11
O.tDr- 19
0.126).9
il
0. r 3
262.16435
296.65195
0.0055,1 0.12554
0.00489 0.12489
0.00432 0.12432
0.0038r 0.r2381
0.00337 0.12337
s47.38509
0.001
231.57 651)
1004.2-s348
1836;/2014
3353.573 28
83
0. 121
83
0.00100 0.12100
0.000-s i
0"12054
0.00030 0.12030
"/.3'7229
7..18()96
35
i.73866
7.80590
7 .86554
7 91844
7.96536
8.00697
8.04387
8.07660
8.10s64
8.20837
8.2617 5
8.29570
8.31268
690
*r = l5.M7o
n
F/P*r,n
P/F*r,n
1.07889
1.25350
1.45636
1.69204
1.96587
7.M667
2.28402
2.65365
0.43865
0.37755
3.0831
0.32496
2
3
4
5
6
7
8
9
10
11
t2
13
t4
15
16
l7
t8
t9
20
2t
))
)t
3.58206
4.161'16
F/A*r,n
A/F*rrn
A/P*rrn
P/A*rrn
0.92861
1.07889
0.79927
0.68793
0.59211
0.50963
0.92687
0.42874
0.26394
0.18246
0.13429
1.07687
2.33239
0.57874
0.41394
0.33246
0.28429
0.92861
1.72788
2.41581
9.73069
12.38434
0.10277
0.25277
0.08075
0.230't5
15.46'7 45
19.04950
0.06465
0.05249
0.04308
0.21465
0.20249
0.19308
0.18566
0.17971
0.17488
56.58491
0.03566
0.02971
0.02488
0.02093
0.01't67
l8
78.71403
92.53154
0.27969
0.24013
4.8352'7 0.20720
5.61778 0.17834
6.52693 0.15350
7.58322 0.13212
8.81044 0.It37l
10.23627
l1.89285
.13.81752
16.05367
18.65170
21.67018
25.17716
29.25t69
0.09788
0.08424
0.07251
0.06241
176.96241
374.62942
793.09049
t678.9'7258
0.16497
6.06188
0.0t270
0.t6270
6.t4612
0.01081
0.00921
0.16081
0.1592t
0.00786
0.15786
6.21863
6.28104
6.33475
0.1542t
2,16.90721
0.00361
0.15361
322.68299
0.00310
0.00266
0.00228
l0
6.53172
0.t5266
0.15228
6.550s2
6.s6670
0.00169
0.r5196
0. l5 169
6.58062
6.59261
0.00079
0.15079
0. l 5037
5687.05842
0.00037
0.000 r 8
t2046.94943
0.150r8
0.00008
0.15008
6.63168
6.65014
6.65886
6.66298
0.01 393
35
0.01497
0.fia93
6.38099
6.42078
6.45503
6.48451
6.50988
7 t .94'7
40
45
50
66.821
0.16767
5.38633
5.56467
5.71817
5.85029
5.96401
0.00672
0.00574
0.00492
0.00421
0.02184
0.01880
0.01618
55
40.19125
47.77447
5.17913
t48.9C7tO
174.08426
203.33595
237.32156
53.3000s
6t.92583
83.591t2
33.6U32
4.93840
0.04623
0.03979
0.03425
0.02948
0.02s37
26
27
28
29
30
28.U653
3.95620
4.33375
4.65871
108.58521
127.23691
33.98561
39.48565
578
23.2r126
3.00792
3.51756
0.05372
24
25
45.87
3.78875
5.48079
0.01199
0.00566
0.00267
0.00126
0.00060
375.98305
437.90887
s09.85612
593.44754
1263.77512
2682.8s862
0.00r 96
0.15672
0.15574
0.15492
0. r53
691
*r = ?O.tltl%o
n
I
2
F/P*rrn
P/I*r,n
!'/A*rrn
r.10701
.35211
0.90635
0.74205
0.60154
:.45qQ
-l
1.65 t 17
2.01711
2.46310
3.0091
3.67512
4.489 r 6
5.48308
6.69704
l0
ll
12
t3
t1
l5
8.t7979
9.9908 r
12.20281
14.90454
r8.204.15
l6
'22.23491
t7
:7.157E5
18
19
2A
2t
22
23
,ri. 17067
4u.51475
49.484n3
60.4,10e1
73.8',2269
e0.t6723
:4
:5
r r0.130_51
26
27
29
161.29541
200.67087
245.09996
299.36576
30
36s.646t7
r8
3s
40
45
50
I .:iJ.5
l37l
993.92933
270r.7800s
7341.1996t
19961.60433
i.1 0701
0.49i11
-l I t{159
(, I l?70
4.40725
8.-59141
0.333,13 1.110058
0.272e9 15.I76i)0
0.22350 19.76-s l6
0.18299 25.24E24
0.14982 31.94528
0.12266 40.12507
0.r0043 50.il5E8
0.08222 62.31ri69
4.06732 77.22323
0.0551I 9:..11768
0.04512 lt7.^6265
0.03694 144.s20,50
0.03025 17'r _99117
0.02476 218.s0592
d.02028 267.99015
0 0r660
328.43t66
0.01359 402.25134
0.011 r3
492.42158
0.00911 602.551t)9
0.00746 737.06-ss0
0.0061 1
90t.36121
0.00500 I r02.03208
0.00409 134'7.13204
0.00335 1646.49180
0.00214 2012.14397
0.00101 5478.16579
0.00037 t4899.78994
0.000 l4
405 l 0.4 964
1
0.00005
110127.32897
.1.75106
0.008-50 0.20R-50
4 79619
36
0.001 l1
36
0.201 l1
0.00091 0.20(),) I
0.0i:
0.20i
4.96631
4.9i242
4.917 42
692
*r
n
1
2
3
4
5
6
7
8
9
10
11
l2
13
t4
l5
16
t7
18
19
20
2t
)',
23
24
25
F/?*rrn
P/F*r,n
,F/A*r,n
1.13610
0.88480
0.68908
0.53666
2.59489
4.46800
1.45878
1.873 I I
2.405t3
1.13610
0.4t795
6.873t3
3.08824
0.32550
9.96137
3.96538
5.09165
0.25350
0.19742
13.92676
19.0r 841
6.53781
0. I 5375
8.39472
10.77903
o.tt974
25.55622
33.95094
0.09326
44.',t2998
13.84055
0.07263
0.0s656
0.04405
0.03431
0.026'72
58.570s3
76.34215
.77162
22.81921
29.30045
37.62252
r7
48.30827
62.02905
79.64688
102.26861
131.315s0
168.6t244
216.50266
277.99491
3s6.95253
458.33612
26
27
28
29
12.{5.88676
30
1599.7 5A27
35
40
45
t9488.94194
50
=25.00Vo
588.51s23
755.66852
910.29758
5583.67107
68023.11220
237423.99060
99.t6136
128.46181
I 66.08433
0.02081
0.01621
214.39260
276.421C5
356.06853
458.337 t4
0.01262
0.00983
0.00765
589.65264
0.00596 758.26507
0.40464 974.76773
0.00362 t252.762U
0.00282 1609.71517
0.00219 2068.05130
0.00r71 2656.56653
0.00133 3412.23s0s
0.0010,1 4382.s3263
0.00081 5628.41939
0.00063 7228.16966
0.00018
0.00005
0.00001
0.00000
25238.7s243
88101.86318
307
51s.67906
1073345.14608
A.6*r,n A/P*rrn
0.88020 1]3020
P/Atr,n
0.88480
0.63537 L57388
0.47381 2.11053
0.39549 2.52848
0.35039 2.85398
0.07180 0.32180 3.10748
0.05258 0.30258 3.30490
0.03913 0.28913 3.45866
0.02945. 0.2']945 3.s7840
0.02236 0.27236 3.67166
0.01707 0.26707 3.74429
0.013r0 0.26310 3.8008s
0.01008 0.26008 3.844q0
0.00778 0,25778 3.87921
0.00602 0.25602 3.90593
0.00466 0.2s466 3.92674
0.00362 0.25362 3.94294
0.0028 r
0.25281 3.95556
0.00218 0.252t8 3.96539
0.00170 0.25170 3.97305
0.00132 0.25132 3.97901
0.00103 0.25103 3.98365
0.00080 0.25080 3.98727
0.00062 0.2s062 3.99008
0.00048 0.25048 3.99228
0.00038 0.25038 3.99399
0.00029 0.25029 3.99s32
0.00023 0.2s023 3.9963s
0.00018 0.25018 3.99716
0.00014 0.25014 3.99779
0.00004 0.25004 3.99937
0.00001 0.2500t 3.99982
0.00000 0.25000 3.99995
0.00000 0.25000 3.99999
0.38537
0.22381
0.14549
0.10039
693
*r
n
1
2
1
4
5
6
7
8
9
l0
I1
t2
13
r5
l6
16.8il i6
0.059-l I
23.88'ir 3
33.41u59
PIF*r,n
F/A*r.n
1.16620
1.57120
2.12495
2.86838
1.87191
0.86394
0.64002
0.4'7114
2.74040
4.86534
5.22653
7.05507
9.52335
r 2.85518
17 -35268
23.42367
0.19:77
0.14i81
3 1 .61
42.68A72
0.03 1 36
0.02361
I 1 8.66C i8
161.34150
51
0.01;49
21 8.954-14
0.01:',o6
296.723-1
t4.97i62 0.009i,0
0.001 i i
I 91 .28170 0.005i7
40t .70.1:19
865
1.16ti20
'l
0.35 r 25
0.26021
.,"33i2
0.071t37
46.26517
0.058()6
63.618-+6
0.041s6
0.02993
O.021(tl
0.015?2
87.042t3
0.01
0.10579
0.043111
i41.',101e7
t7
I 1.60563
F/P*r,n
.612,)4
71 .76913
l4
= 30.007o
543.406-r6
258.20328,
348.53798
0.00390
734.68805
992.891?4
0.002E9
r31t,4293t
2l
170.4'77A6
22
635.077
2.146.93396
E57.265r)9
0.002 r 4
0.00 I 59
0.001 l8
1552.03883
0.00037
0.000t;5
r8
19
20
:3
r57.18583
21
25
26
11
2 r08.53
28
29
30
60
88 0.00018
0.000_15
18.11 .99557 0.00026
s l86.l5l -57 0.00019
1
2846.22033
7000.5723'.7
0.00014
1.9
il
.906i7
3304.24)45
4461.43588
uor3.4it'/1
8 I 32.00659
109'78.22692
14820.22249
20006.37406
27006.91643
49
0.35941 2.78234
2.92515
0.34 r 86
0.32993 3.03094
0.32t6r 3.10931
0.315'72 3.16738
0.3
149
0.00.q-r3 0.30843
0.00620 0.30620
0.004-57 0.30457
0.00337 0.30337
0.002-19 030219
0.00184 0.30184
3.21039
3.24225
3.26586
3.28335
3.29630
3.30590
3.31301
694
*r = 40.00Vo
F/?*r,n
P/Ilr,n
I
,,
1.22956
0.82420
0.55248
0.37034
0.24824
0.16640
4
5
6
7
8
9
10
rt
t2
13
t4
15
16
17
l8
19
20
2t
)1
23
24
1.83429
2.73644
4.08229
6.09006
9.08530
13.55368
20.2t97 |
30.t6426
44.99979
67.13180
100.14887
t49.40456
222.8854r
332.50597
496.04061
740.00563
I 103.95868
1646.9t283
2456.90523
3665.27190
s467.94315
8157 21263
12169.13127
,<
18154.210s7
26
21082.89970
40402.93865
60274.101'74
27
28
29
30
899 i 8.3936 I
134142.18036
0.1
154
0.07477
0.05012
0.03360
0.02252
F/A{r,n
A/F*rrn
1.22956
3.06385
5.80029
9.88258
15.97264
0.81330
0.32639
0.17241
25.05794
38.61162
58.83133
88.99559
133.99538
0.101 19
0.06261
0.03991
0.02590
0.01700
0.01124
0.00746
A./P*r,n P/A*r,n
1.21330 0.82420
0.72639 1.37668
0.5724r 1.74701
0.50119 1.99526
0.46261 2.16166
0.43991 2.27321
0.42590 2.34797
0.41700 239809
0.41124 2.43169
0.40746 2.45421
0.40497 2.46931
0.40332 2.47943
0.40222 2.48621
0.40148 2.49076
0.40099 2.49380
0.40067 2.49585
0.40045 2A9722
0.40030 2.498t3
0.40020 2.49875
0.40013 2.49916
0.40009 2.49944
0.40006 2.49962
0.40004 2.49975
0.40003 2.49983
0.40002 2.49989
0.40001 2.49992
0.40001 2.49995
0.40001 2.49997
0.40000 2.49998
0.40000 2.49998
*r =
n
1
2
3
;l
5
6
7
8
9
0
ll
II
i-i
l.l
r5
i6
t7
i8
r9
20
2t
1''
l3
24
P/F*r,n
F/A*r,n
A/F*r.n
1.29744
0.78694
0.17i -\0
0.2ri9:,0
1.29741
3.435-i6
5.96338
12.778t1
?:..364rt)
l.526s
e.58688
15.80609
26.0,5983
.12.96540
0.03918
0.023i6
70.83796
0.01441
0.06.i511
3ii. 17 I 07
61.23A90
I 07.1 9630
A,/P*r,n
P/A*r,n
0.770/5
1.27075
0.78694
0.29C,)9
0. l.i-?ti I
1.?6424
0.0;816
0.79099
0.64361
0.57826
0.i't4471
0.5447 t
0.02620
0.01557
0.00933
0.00562
0.00339
0.52620
0.51557
0.50933
1.9396t
4.50562
1.97778
0.50339
1.98652
r.99183
r.90043
1.96337
0.00874
178.03426
291.82632
1e2.55755
0.00530
0.00322
4E7.38386
0.00:05
804.85759
0.50205
0.0012,1
0.001 95
1328.28327
4.50124
2t9t.26632
0.00075
0.00046
0.00028
t.99504
0.001 18
0.000 72
0.50075
0.50046
ri.50028
1.99699
1.99933
1.99959
317
.473i2
523.12568
852.9830s
i422.81851
3614.08483
:.i+-s.33i15
C.00C.,i4
3867 .62111
5959.91597
0.00026
0.000i7
0.-50017
0.00010
t7.45366
0.00004
0.000c2
0.50010
0.50006
0.50004
0.50002
6376.$A17
0.0c0i6
9821.5376s
16204.16786
10513.28_s80
0.00010
0.00006
267
11333.47793
:e)519.0737 6
47 I
1,s5374
1.72933
I .83583
116j9206
i7.27808
7768-r.25859
i28078
'i4082
:5
2r1164.99020
26
1481.52.21098
-574005.95568
a1
1473
0.17 559
0. 106_.)
--i.8
50.00Vo
F/P*r,n
?]3912
695
:8
:9
946375.82863
I s60309.95875
30
25'.72516.21787
0.00004
0.00002
0.00001
0.00001
0.00000
44050.9-i r59
0"00006
i2629.00535
0.0001i
119746.28313
197429.54202
325507.58284
536672.s7304
0.00001
0.000r)0
88482,1.78402
0.00000
0.00000
0.00000
0.00000
1"1-58830.73970
^2.10-5206.56833
39655 16.52708
6538032,74494
0.50001
0.50001
0 50001
0.00c01
0.00000
0.00000
0.50000
0.50000
0.00000
0.00000
0.00000
0.00000
0.00000
0.50000
0.50000
0.50000
0.50000
0.50000
I .998
l8
r.99889
1.99975
1.99985
1.99991
1.9gg94
1.99997
1.99998
1.99999
1.99999
2.00000
2.00000
2.00000
2.00000
2.00000
APPENDIX D
that rariable costs, and thereibre total costs, vary linearly with production
rate instead of non-Iinearly as illustrated in the generai schematic shown in
Figurc D-1.'fhe linear approxirnarion case often is found to be a useful simpiification ot the general nonlinear cost situation.
rotat
C,tstS
a/
-/
Total
Cost
?r
Income
Production Rate----->
Figure
EXAtulPLE
Solution:
Figure D-1a graphically illustrates this problem. However, the graph
is not developed with sufficient accuracy to give good numerical results
for the questions asked so the mathematical solutions are presented.
698
10,000
8,000
Incomes
OT LOSTS,
Dollars
6.000
4,000
Cp
2,000
0
500
1000 1s00
2000
Production, lb/month
Figure
D-la
a) Variable Cost per lb, Cv is the slope of the total cost curve.
Therefore,
6000
1500
5000
$2:00 per [b.
1000 =
given yields:
$5000 = Cv (1000) +
C5
D-2
Cp
D-3
and
$6000 = Cv (1500) +
lf we had not already calculated C, from the slope of the total cost
curve, we could subtract Equation D-2 from D-3 and obtain C, =
$2.00/lb. Knowing Cy, w can substitute C, = 2.00 into either Equation D-2 or D-3 and calculate Cp = $3000.
699
c) Knowing Cp = $3000 gives a $3.00 fixed cost per lb for the first
1u00 units.
cr"
d) The total cost per unit for the first 1000 lb/month is $5000/1000
= $5.00/lb. lt could also be found from C, + Cpl1000 = $2.00 +
$-r.iO = 55 C0/lb.
ticn and the income equation. Let X represent production rate per
n:clih.
D-4
D-5
Solving Equations D-4 and D-5 for the production rate, X, that will
make Total Cost equal lncome gives the break-even production rate.
2X + 3000 = 10 X or X = 375 lb/month to break-even.
2(1000)
3000
It is worth mentioning at this point that in numerous places in journal literature and textbooks you will find the following equation given
to calculate the break-even production rate:
Break-even
Fixed Cost
Production =
Selling Price/U nit-Variable Cost/Unit
Units
700
Total
Cost
lncome
60 tons of rice hulls per day must be disposed of by a rice bompany. Pollution problems concerning incinerating or burying the hulls
have forced the company to accelerate efforts to convert the waste
rice hulls into a usable product. The cost of disposing of the rice hulls
is $4 per ton for the 60 tons per day, 300 days per year operation. A
proposed process estimated to have a fixed capital cost of 9200,000
can be installed to convert the waste rice hulls into 60 tons per day
cjf usable product. Operating costs are expected to be g200 per day
of operation. lf the $200,000 first cost of the process is recovered in
3 years, what selling price per ton must be recovered for the product
to break-even with the present loss of $240 per day? Assume the
minimum RoR is 15% before taxes. what selling price will completely eliminate the present loss of $240 per day? Use before-tax
analysis.
Solution:
Disposal Annual Cost = (60 tonsidayX$a/ton)(S00 days/year)
= 972,000
.4380
Process Annual Cost = 200,000(A/P1S,3) + 60,000
= 147,600
701
$18,0CiC X
To break even with no loss and realize a 15o/o ROR on new investfi,giris:
518,000 X = 147,600
X = 99.20/ton
\l/ith
l'he incremental cost concept is very important to evaluate optimum levels of production activities and to determine pricing to yield satisflctcry
profit margins. Marginal cost per unit and differential cost per unit are other
corlln-lon naffles used interchangably tbr inclemental cost in the literatu:e.
Different production levels are mutuallv exciusive, so the incremental cost
!
c()ncept is applicabie to titis type of prohlem.
Incremental operating costs can be calculated either from total cost r,..sus prs6lxglion rate dara or variable cost ','ersus production rate data. Since
the total cost curve is forind b1 adding the constant fixed cost to the variable
cost, change in total cost ior a given change in production level is identical
to the change in'variable cost. That is, incremental total cost equals incremental variable cost. The following example illustrates the use of incremental operating costs for the economic evaluation of a manufacturing process.
702
Rated
Capacity,
Pumps
Vari-
Fixed
Manufactured Cost
%
00
2s%
50%
75%
100%
125%
150%
175/o
able
Total
Cost
Cost
$10,000
1000
2000
3000
4000
5000
6000
7000
10,000 15,000
10,000 20,000
10,000 23,000
't0,000 29,000
10,000 43,000
10,000 62,000
10,000 85,000
Total
lncremental
Clg{Pump CosVpump
$10,000 $
2s,000 25.00
30,000 15.00
33,000 11.00
38,000 9.50
53,000 10.60
12.00
95,000 13.57
72,OOO
$15'00
5'00
3'00
5'00
15'00
'19'00
23'00
703
than the total cost per pump at the last level, the new total cost per
pump must be lower than the previous one. Thus, minimum incremental cost per unit and minimum total cost per unit usually do not
occur at the same production level. lt is only coincidence if they do.
The break-even poini for cost to equal income at the reguiar $20
per pump price may be seen to be about 1300 pumps on the breakeven clrart shown in Figure D-2. Mathematicali), the break-even
point ri^,ay be foun,J ;:,;ie s;iactly as foliows:
Evaluate the data given in the problenr statement and find that the
break-even point occurs between 25"/" and 50% of rated capacity.
Assume the total cost curve is a straight line in this range with slope
= (30,000 - 25,000)i(1000) = 5.0. The equation for the cost curue in
the break-even range is
Tctat Cost = 5.0(X) + K
D-6
where X equals production rate for 1000 < X < 2000 and K is the
pseudc fixed cost where the total cost line intercepts the cost axis at
zero production rate. Since Total Cost = 25,000 when X = 1000, we
see that K = 20,000. Obviously this K value is a pseudo fixed cost
because we know the actual fixed cost is $10,000,
Tctai Cost = 5.0 X + 2C,000
D-7
D-8
Note on the break-even chart that the slope of the total cost curve
between operating levels equals the increment cost between those
levels. For $20 per pump sold, maximum profit occurs at 6000 units
sold. To maximize total profit, increase sales until the slope of the
total cost curve equals the slope of the income curve. At that point,
selling price per unit equals incremental cost per unit. Further
increase in sales would erode profits.
704
Cost or
lncome,
Dollars
'100,000
80.000
60,000
6ot'
Breakeven
Variable
40,000
Cost
20,000
CF
Fixed Cost
6000
7000
l,
_^t
705
nlental co:jt per unit rcsults to be sure that they are satisfactory. One of the
C)[ incorrect management decisron maliing concerning
mutuallv exclusive alternative decisions is to base a decision on total investnreri anrl).sis or total cost per unit analysis instead of properly evaluating
nlr)st corllr-lon causes
a) lncome
b)
= 750
-Total OC = 575
Profit
Total
= 175
O.C.
= 575
c)
Variable cosVunit
= 90.50
+Fixed cosVunit = $200/750 = $0.2
Total cosUunit
At first glance these calculations often lead people to the incorrect conclusion that it is economically desirable to purchase externally for any purchase price less than $0.77lunit. Actually, if it costs more than the $0.50
variable cost/unit to purchase externally, the economics favor producing
internally because the difference between the external cost/ unit and the
$0.50/unit out-of-pocket variable cost/unit can be applied to pay part of the
fixed costs,. which will be incurred whether we buy or produce. The incremental difference between the total costs at any two levels of operation
leaves the incremental variable cost which in this problem is $0.50 per unit
at all levels of operation.
APPENDIX E
0
Figure
2g
3-
(n-2)g
(: -l)s
n-l
B is spread uniformly each period over the project life. Now if we can
spread the arithmetic gradient payments uniformly over each period of the
project life we will have converted the gradient series to an equivalent series
of equal period payments. The future worth of the gradient terms at year n is:
F
/\/\
= e[F/P;.(n-z),,l+ 2s[F/Pi.(,-3)J
+. +("-z)g(n7ri,z)+(n-r)g
E-1
F(F/pi,lJ
/
\ -(-,^
= s[n/r,,("_l)J+ 2s[F/P1,1
+
...
(, - z)g(r7ei,z)+
707
)
"_4 )
1n
- r)g(n7e,,,)
E-2
708
-s.
[-rF/Pt., * t/0,., *_
+ (n
j.
1)g =
vo,,(r-r) * vt,,(4 * ,*
F/Ai,n
F-F(l+i)=-g[r7a;,n]*ng
or
Fi =
E_3
*g[r7a1,n]-ns
Dividing by i gives
F=
i -llil
g[F/li,"
"L
E-4
n = n(e7r,.. = r[i)
i (oro,., )] = ,(o7o ,, ;
E-s
The arithmetic series factor (also called a gradient conversion factor in engineering economy literature) is bracketed. Adding the first term in a gradient
series, B, to Equation E-5 gives the total arithmetic gradient series equation
presented in chapter 2 as Equation Z-lZ
/\
A=Bts(A/c,.n)
z_12
1 gram (g)
1 kilogram (kg)
1 metric ton (mt)
1"4
2,000
2,240
2,205
0.035
2.205
pounds
pounds
pounds*
ounce*
pounds"
'1,000 kilograms
= 1,000
f,{M = 1,000,000
1 Mcf
'1
MMcf
1 barrel (bbl)
1 neter (m)
1 kilo:":eter (xm)
42
U.S. gallons
640
1
36
acres
square mile
square miles
3,279 feet*
A.622 mile"
Energy:
'1
kilowatt (kw)
1 kilowatt (kw)
1 Mcf of natural gas
1 kilowatt-hour (kwh)
1 megawatt
1,000,000 watts
1 mill
SELECTED REFERENCES
.,{
_l
S,'lected Heferences
711
)'.'*'
Y'ork, lt)8.1.
Grant, E.I-., Ireson, W.G., ernd Leavenworth, R.S., "Princples of Engineerrng Economy," Seventh Edition, Ronald Press Co., New \brk, 1985.
Harris, Deverle P., Mineral Exploration Decisions, A guide to Economic
Analysis and Modeling, John Wiley & Sons, New York, NX 1990.
Henderson, W. Matthew, "Impacts of the Alternative Minimum Tax on
712
987.
stewart, G. Bennett III, The euest for value - The EVATM Management
Guide, Harper collins, publishers Inc., united States of America, 1991.
The options lnstitute, options, Essential concepts & Trading strategies,
Third Edition, The Educational Division of the chicago Board optlons
Exchange, McGraw Hill, 1l West 19th Street, Ny, Ny 10011, 1999.
Thompson, Robert S., Wright, John D., ,,Oil property Fvaluation,', Thomp_
son-Wright Associates, Golden, CO, 19g4.
Thuesen, H.G., Fabrycky, W.J., and Thuesen, G.J., ,.Engineering Economy,,,
Seventh Edition, Prentice-Hall,Inc., Englewood Cliffs, N.J., 19g9.
weston, J. Fred, and copeland, Thomas E., "Essentials of Managerial
Finance," Tenth Edition, The Dryden press, 1992.
woolsey, R.E.D., and Swanson, H.s., "operations Research for Immediate
Application," Harper and Row, New york, 1975.
INDEX
i70
w'ith dual rates of return,2A2*215
Accounting rate of return, 48 I
Acquisition costs, 107, 351, 462461
Add-on Interest, 41
Additional tax on corporate income, 382
registered, 6 I 9
savings, 621423
Alter-tax
analysis of mineral and Petroleum
projects, 119427
cash flow, 327
NPV and DCFROR, 338,400,462
,VG factor,46-47
Altcnratives
rlr-rlually exclusive, I 64-1 85
non-mut'.rally exclusive. 22 I -133
i\lternativc Njinimum Tax (AIv1T)' 371
... ii ;r'reli.,,: order, 626
,\ r;erican--ctyle option', 600
;'..;
fixed,6l6
cun'ent,616
trxtl.5l6
Assets as representative of organizational or,
persr-.nal
value,6l6
Balloon payment,555
Bear market, 597
6-9,327
diagram of,32'7
\sets
(, , 9
gonl'siir,r[e,618
'coupon. 619
junk, 624
municipal or tax-exemPt, 623-624
"new" bond rate, 82
life, 344*345
Collateral. 618
Common stock, 59-l-595. 617
Cotnmon stock index, 607
Comparable sales technique of valuation, 460
Completion costs, 129, ?14-345
Compound interest factors
applications of' 35-4 t
applications summarY, 23
single paYment, l8-19
uniform series, 19-21
Constant dollar analYsis, 246-258
rate of return, 254
713
714
670,682
Continuous flow of funds, 30-35, 682
Convertible bonds, 618
Convertible debentures, 6 I 8
Convertible preferred stock, 618
Corporate taxes, 382
for C type, 379,382
for subchapter S, 379, 381
Costs that may be expensed for tax, 33V334
Cost analysis, 136, 505
versus net value analysis, 189
Cost of borrowed money, 87, 553
Cost of capiral, 12-14,87
Cost depletion, 350-352
Cost of goods sold, 407
Coupon bonds, 619-623
Covered option, 602-606
Cumulative cash position diagram, 72
Cumulative preferred stock, 617
Currency exchange rate considerations,
415419
Currerrt dollar values, 249
Current yield, 84
Day order, 626
DCFROR, 9,419
Debentures, 82, 616, 618
convertible,6l8
Debt options, 609
Decision making concepts, 4-6
Decision tree analysis, 299,303
Declining balance depreciation (DDB), 340
Deductions
book, 327
non-cash, 327
ourof-pocket, 330
reporting for tax and shareholdeq 470
Defender, 505
Deflated dollar values, 249
Depletion, 350
cosr, 35 I
methods ol 350
percentage, 352
Depreciation, 333-350
declining balance, 335, 340
half-year convention, 336
influence of method on after-tax rate of
return, 400
MACRS,344
mid-quarter convention, 336
personal property, 334
(DCFROR),4r9
Discrete interest, 16-27
compared to continuous, 29-34
Diversification of investments, 591, 632
Double declining balance depreciation, 340
switching to straight line,342
Doubling of investment, 37
Down-tick, 598
246,249
mutually, 164
non-mutually, 221
Expected cost, 299
Expected Net Present Value (ENPV), 300
Expected profit,299
Expected rate ofreturn, 301
,1dex
715
Ilxpectcd
'alue,299
165
Indentures. 6 I 8
Index options. 607
Individual rerirement account (lRA),
jiil apt:Jll.J]ces)
r.r; ii:re, fi
'liic accounted for. 299
l.,.ni in. i
:.
lil
6l I
4-5
ftcdgcrs.6l3
Honre. prirchase vs. Iease. 635_6lg
l54l
627-633
Individual tax rates, 381
nominal,23-25
simple. 23-?5
Interest tables, 6,18 (see appendices)
Internal rate of rcturn, (see Rate of Return)
Interrrational project e\.aluation, 4 1 5
Interpolation, 35, 68-o9
In-the-money, 601
Intrinsic value. 602
Inventory problems, 407
Investment decision analysis, l-6
Investment efficiency, (see present value
ratio)
Investment-income-investment analysis, 201
Investment portfolio, 59 I
Investment tax credit, 395
Investor rate ol retum, 3 78
Joint Venture Considerations, 562
Junk bonds, 624
Land, treatmenl for tax, 33.4
I ast in-first our (LIFO) accounring, 407
Leasing compared to purchasing. -5 l -j
with leverage, 520,578
Leverage and borrowed money, 553
Liabilities, 61ffi17
current,61ffi17
Iong term, 616-617
short term, 616-617
total, 616-617
716
Lives
projects with long, 122
comparing alternatives rvith equal, 132
comparing alternatives with unequal, 139
eff'ect on evaluation results, 122,193
service, l32
Load funds, 592
Loan points, 44
Long position, 596-597
Loss carry forward accounring, 361,362-365
Margin, 590
Marked to the market claily, 614
Maturity value, 82
Mid-month convention, 337
Mid-quarter convention, 336
Mineral development, 332
Mineral rights acquisition. 35 I
Minimum rate of return, 12, 87
changing with time. I84
under leverage, 573
Nrlinimum rax, 391
N{ining Projects
analysis of, 124.419
tax considerations, 33 1-332, 345, 350,
419
Net u,orth,6l6
No-load lunds, 592
Nonrinal Interest. 23
Non-cash deductions, 327
Non-cumulative preferred stock, 61 7
Non-mutually exclusive projects, 22 I
Open ordeq 626
Operating lease, 514
ofcapital, l2
Out-ofthe-money, 601
Over-bought. 596
Over-sold,596
Over-the-counter market, 625
PlA factor,22,23
Participating preferred stock,
61 7
Payback peiod,437
Percentage deoletion, 350, 352
Period interest rate, 24
Personal income taxes, 381
Personal investments, 589
Personal property, classes'of, 334
Petroleum projects
anaiysis of, 128-131, 419
tax considerations, 332, 345, 165, 419
P/Ffactor, 17, 19
Preferred stock
cumulative, 617
convertible,618
non-cumulative, 617
participating, 617
Prcmium. 600
for Treasury Bond and Note options,
610
on foreign currency, 610
on options, 60;l
Present value, 6. 16, 19,21-22
Present value ratio (PVR), I l3
Present worth (PW), (also see Present value)
equation, 65
single payment factor, 18, 23
uniform series factor, 22, 23
Price to earnings ratio (P/E), 596
Probabilistic analysis, 288
Prolitability index, 1 l2
Programrned trading, 609
Property depreciation
declining balance, 340
real,334,346
rental, 346
personal, 324, 346
lncex
717
straight
r-rnits
line.337
of plL:duction,
P'r
I
*
'
1
,
'
i
'
.
Salvage value
343
tax treatment
513
600-605
i'\i(.rr.r- i;:sentvalueratio)
P\\'. (sce Pr,'.cnr worth or Nct Present
:'.r, .-t: tDl;, , rch t'ir evaluation. 288
ol
385-390
Savings
analagous to income, 443
NPV and DCFROR caiculations,
Value)
r.a;rrin: altrnetircs
i,Jn rlrurirril\ exclusive,221
of,67-70
rates,201
growth, 98
incremrntal, 132,164
introdrrction of,9,51,62
rneanit:s wlien incolne precedes cost,
19:l
reven're reinvestment, 93
R,.::oa:::.lvsis. 112,222
F.cal doiier values, 249
R.:rl estate
ri],,estment with leverage, 564
R.':al pr"opertr'. dcprec., -13.+, 337, 345,316
F :cir-',rre
:'l',- .:pcnscJ exploration costs,
I
tr- -:',r12riiri1 cosls. 209
F. - isre:i,.J bonds. 619
! -.:abilitaiion tax credits, 395
R.- nvestrnent question, 93
ciual
3-1.
443445
Seliingagailrtthen,.rx,59.9
Sensitivitl.ar,.rlysis. 182-293
parameters. 282a93
rvith borrow'ed rnfney or cash. 556
Service life analysrs. 132--118,189, 194
Service producing alternatives
different service, 144
same service. 132-144
unequal lives, 139
Shareholder reporting deductions, 470
Short position, 597
Simple interest,24,4043
Single payment factors
compound amount (FlP), 18-19
present \\,orth (PlF), 19
Sin}:ingfund.2l,618
Sinking fund deposit factor (NF),21,23
Speculative value, 601
Speculators, 613-614
Spread, 606
Stand alone, 361
State inclme tax, 394
combjned with f'ederal, 394
Stock dividend. 606
Stock split, 606
Stop order, 626
R.r,nvstmentrequirement,93-103 Stoplimitordet626
Re.:lacement
rnalysis 132-146
,
Straddle, 606
Straight line depreciation, 337
Study period for unequal life alternatives, 139
SuUctripter S corporition, 379
Successtul efforts accounting, 475
Sunk costs,4zl5
in replacemcnt analysis, 529
R.'search
Rct'rrn
on assets.4"8
value)
.178
on capital ernploved,
Revenne reinr,c:tment, (see Growth rate
I82
Rights, 606, 6l I
Risk analy'sis, 284,299
ROR. (see Rate of return)
Round lot, 597
Rulc' of "72'". 36
Rule of "7ti". 4 I
rctr-rrn).
98.
Tax
of
allowance,3-]3
credits. 395
deduction timing and cash flow, 400
Tax deferred investments, 627
Tax free investments, 627
Tax sheltered investments, 627
Technical analysis regarding stock market,
626
718
626
Time order,
Time value of money, 6-12,
Time value of options,
1540
601402
Timing assumptions, 27
Today's dollars, 250
Trading crorvd, 625
Treasury bit! (T-Billt, 86
Uncertainty, 282,284
Unequal life alternative comparison,
171
617
Warrants, 606
139,
Working capital,406
Working interest, 124
Yield
culrent, 84
to maturity, 83
Zero coupon bond,76, 93,619-624