ANNUITIES & DISCOUNTED CASH FLOW RATE OF RETURN

ANNUITY EQUATIONS
ARE USED TO EVALUATE DIFFERENT OPTIONS FOR FINANCING PROJECTS THE BASE PROJECT FOR THIS CLASS ASSUMES THAT THE PROJECT IS 100% FUNDED BY THE COMPANY FROM AVAILABLE FUNDS. 100% EQUITY DEBT FUNDING - MORE TYPICAL FUNDING IS ON THE ORDER OF 20% - 40% EQUITY WITH THE REMAINDER AS DEBT 60% 80%.

EXAMPLE OF ANNUITY CALCUATIONS

GIVEN : WANTED : BASIS : Investment in a plant is to total $12,500,000. Determine which funding option is best for the facility. The funding will be based on a 30% equity position. The available funding combinations (Term, Interest Rate, Loan Cost) are: Case 1: 10 Years, 6.75%, 1.25%: Case 2: 15 Years, 6.95%, 1.375% Case 3: 20 Years, 7.15%, 1.5% Case 4: 25 Years, 7.5%, 1.75%. SOLUTION : Equity := 0.3 Debt := 1 Equity Debt = 0.70

PInv := Debt Investment ot Investment ot := 12500000 T T PInv = 8750000.00 Calculate the loan principal and the payment for each case:

ANNUITY EXAMPLE
For Case 1: n := 10 Pact := PInv (1 Pts) i (1 + i)
n n

i := 0.0675 Pts := 0.0125 Pact = 8860759.49 R1 = 1247033.30 i := 0.0695 Pts := 0.01375 Pact = 8871989.86

R1 := Pact

(1 + i) 1 n := 15

For Case 2: Pact := PInv

(1 Pts) i (1 + i)
n n

R2 := Pact

(1 + i) 1

R2 = 971022.77

ANNUITY EXAMPLE
For Case 3: n := 20 i := 0.0715 Pts:= 0.015 Pact := PInv (1 Pts ) i (1 + i)
n n

Pact = 8883248.73 R3 = 848316.57 Pts:= 0.0175 Pact = 8905852.42

n

R3 := Pact

(1 + i) 1

For Case 4: n := 25 i := 0.075 Pact := PInv (1 Pts ) i (1 + i)

n

R4 := Pact

(1 + i) 1

R4 = 798950.00

RESULTS OF EXAMPLE
THE RANGE OF VALUES FOR THE REGULAR PAYMENTS IS $798,950 TO $1,247,033 PER YEAR THE LOWEST PAYMENT VALUES OCCUR WHEN THE NOTE IS PAID OVER THE LONGEST PERIOD OF TIME THIS IS ALSO ASSOCIATED WITH THE HIGHEST INTEREST RATE

RESULTS OF EXAMPLE
THE RANGE OF THE PRESENT WORTH VALUES IS FROM $8,860,759 TO $8,905,852 THE LOWEST PRESENT WORTH OCCURS WHEN THE LOAN COSTS (POINTS) ARE MINIMIZED THIS IS ALSO ASSOCIATED WITH THE LOWEST INTEREST RATE AND SHORTEST TERM SO THE BEST OPTION IS THE ONE THAT HAS THE LOWEST PRESENT WORTH VALUE

PRESENT WORTH ANALYSIS

PRESENT WORTH VALUE THIS IS NET PRESENT WORTH OF ALL THE PAYMENTS THAT WILL BE MADE TO COMPLETE THIS LOAN THIS METHOD PROVIDES AN OBJECTIVE BASIS OF COMPARISON EVEN THOUGH THE TERMS, INTEREST RATES AND LOAD COSTS ALL VARY. THIS IS ONE VARIATION OF THE DISCOUNTED CASH FLOW RATE OF RETURN (DCRR)

FORMAL DCRR
SEE PAGE 328 FOR REFERENCE FORMAL VERSION OF CALCULATES THE DCRR INTEREST RATE THAT WOULD YIELD A NET PRESENT WORTH OF $0 FOR A PROJECT OVER A SPECIFIED LIFETIME SOMETIMES CALLED INTERNAL RATE OF RETURN, INTEREST RATE OF RETURN, INVESTORS RATE OF RETURN

INVESTMENT PERIOD (DCRR)

FOR THIS CALCULATION, AN INVESTMENT IS MADE IN A FACILITY OVER A SPECIFIED CONSTRUCTION TIME PERIOD THESE VALUES START AT YEAR ZERO THEY ARE EXPRESSED IN CURRENT (CONSTANT VALUE) DOLLARS FOR EACH YEAR THEY ARE CONSIDERED NEGATIVE VALUES BECAUSE THEY ARE EXPENDITURES

PROFIT PERIOD (DCRR)

THE RETURN IS CALCULATED FROM THE PROFIT EARNED DURING OPERATIONS THESE VALUES START IN THE FIRST YEAR AFTER CONSTRUCTION THEY ARE EXPRESSED IN CURRENT DOLLARS, OVER THE LIFE OF THE FACILITY THESE ARE CONSIDERED POSITIVE VALUES BECAUSE THEY REPRESENT NET PROFITS

DCRR CALCULATION
BOTH THE INVESTMENT AND THE PROFIT RETURN ARE DISCOUNTED BACK TO A COMMON TIME AT YEAR ZERO FOR THE OVERALL PERIOD j WHICH IS THE SUM OF THE CONSTRUCTION AND OPERATION PERIODS FOR EACH YEAR THE CALCULATION COULD BE BASED ON THE FORMULA
Pn = Fn (1 + i )
N

(8 6 )

DCRR INTEREST CALCULATION

THE DCRR IS THE VALUE OF i WHEN

Pn
j

=0

WHERE j IS THE LIFETIME OF THE PROJECT

DCRR EXAMPLE
GIVEN : WANTED : BASIS : Investment in a plant. Determine the DCRR for this project. The investment in the plant (in current $) will be $5,000,000 PER YEAR expended over a three year period. The plant is expected to operate for a period of 20 years and produce a profit (in current $) of $2,500,000 each year of operation The investment costs can be calculated using equation 7.24 over a three year period: nc := 3 R c := 5000000 NPW Inv Rc ( 1 + i)
nc

SOLUTION :

1
nc

i ( 1 + i) The return can be calculated using equation 7.24 for the 20 year period from year 4 to year 24 using 7.24: no := 20 R o := 2500000

DCRR EXAMPLE CALCULATION

The easiest way to complete this calculation is to first calculate a NPW based on then end of construction as year 0, which would actually be a future worth in year 4: S4 Ro ( 1 + i)
no

1
no

i ( 1 + i)

and then discount this value back to the start of construction: NPW Ret S4 ( 1 + i)
4

The DCRR occurs for i when: This is a trial and error solution.

NPW Inv + NPW Ret Assume : i := 0.1

DCRR TRIAL & ERROR

NPW Inv := Rc ( 1 + i)
nc

1
nc

NPW Inv = 12434260

i ( 1 + i) S 4 := Ro ( 1 + i)
no

1
no

S 4 = 21283909

i ( 1 + i) NPW Ret := S4

( 1 + i)

NPW Ret = 14537196

NPW Proj := NPW Inv + NPW Ret

NPW Proj = 2102936

DCRR EXAMPLE RESULTS

Completing the Trial and Error Calculation: Ro 1
nc

( 1 + i)

no

1
no

f(i) := Rc

( 1 + i)

nc

i ( 1 + i) ( 1 + i) i := 0.15
4

i ( 1 + i)

For an initial guess:

root(f(i) , i) = 0.1185 DCRR := root(f(i) , i) DCRR = 11.85%

ANALYSIS OF DCRR RESULTS

THE RESULTS INDICATE A DCRR OF 11.85% IN THEORY, IF THE PLANT WERE 100% FINANCED, A LOAN AT A RATE OF 11.85% COULD BE PAID BACK OVER THE LIFE OF THE PROJECT

DCRR APPLICATION
THE EXAMPLE CAN BE USED TO DEMONSTRATE THE ADVANTAGES OF DEBT FINANCING THE CALCULATION CAN BE REPEATED WITH AN ASSUMPTION OF 25% EQUITY FINANCING AND REDUCING THE PROFIT EACH YEAR TO ACCOUNT FOR INTEREST PAYMENTS THE RESULT SHOWS THE DCRR INCREASES TO 30% FOR THE DEBT FUNDING APPROACH

COMPARISON OF ALTERNATES
THE RESULTS OF THE REVISED DCRR CALCULATION SHOW THAT A PROJECT THAT HAS 100% FUNDING MIGHT HAVE A RELATIVELY SMALL DIFFERENCE ABOVE CURRENT INTEREST RATES AND NOT BE ATTRACTIVE THE SAME PROJECT WITH DEBT FUNDING MAY HAVE A RETURN COMFORTABLY ABOVE THE CURRENT INTEREST RATES

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OTHER COMPARISONS
THE SIGNIFICANT VALUE TO THIS TYPE OF CALCULATION IS BASED ON OBJECTIVE COMPARISON OF VARIOUS TYPES OF PROJECTS AND/OR VARIOUS CONFIGURATIONS OF ONE PROJECT INDEPENDENT OF PROJECT LIFE INDEPENDENT OF CURRENT INTEREST RATES

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