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Net Present Value (NPV): the Basics & the Pitfalls

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Net Present Value (NPV): the Basics & the Pitfalls Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com Net Present Value (NPV): The Basics & The Pitfalls Cobec Consulting Kevin Schutt, Manager Nathan Honsowetz, Consultant ICEAA Conference, June 2013 Agenda Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 2 Time Value of Money Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com Discount Factor “A nearby penny is worth a distant dollar” ‐ Anonymous 3 Time Value of Money Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com Year 1 2 3 4 FV1 FV2 FV3 FV4 PV1 PV2 PV3 PV4 4 Inputs to NPV Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 5 NPV Example Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 6 Investment Alternatives Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com If NPV > 0 No correlation IRR > Cost of Capital Benefit/Cost > 1 7 Economic Analysis Regulations Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 8 NPV in the Private Sector Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 9 Net Present Value: The Pitfalls Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com Pitfall! Activision, 1982 10 NPV Pitfall #1: Formula error Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com Which is the correct formula to determine year t’s Discount Factor? • 1/(1+r)t • (1‐r)t (where r is the discount rate) There is a difference: r = 10% Sum (PV) t = 1 2 3 4 5 6 7 8 9 10 1/(1+r)t 6.14 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 (1‐r)t 5.86 0.900 0.810 0.729 0.656 0.590 0.531 0.478 0.430 0.387 0.349 If your initial investment was $6, (1‐r)t would have resulted in negative NPV and a decision to reject the investment! 11 NPV Pitfall #2: Inflation Treatment Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 12 NPV Pitfall #2: Inflation Treatment Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com • Not correct! • The example discounts a real (no inflation) cash flow with a discount factor that includes an inflation assumption (nominal) • Two ways to approach this correctly: • 1) Convert cash flow to nominal and compute PV using the nominal discount rate: • Convert cash flow to nominal: $100 x (1.02) = $102. • Discount nominal cash flow: $102/1.09 = $93.58 • 2) Convert discount rate to real and discount the real cash flow: • Convert discount rate (solve for r) • (1+r)*(1.02) = (1.09) • r = 1.09/1.02 –1 = 6.8627% • Discount real cash flow • $100/1.068627 = $93.58 13 NPV Pitfall #3: Excel’s “=NPV()” Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com • Microsoft Excel’s function NPV() is really just a Present Value function, returning the value of a cash flow stream at time t = 0 • The “netting” of any initial investment (t = 0) must be programmed in by the user 14 NPV Pitfall #3: Excel’s “=NPV()” Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com Example The first calculation includes the initial investment in the NPV function, incorrectly discounting it as a result The second calculation uses the NPV function only to discount the cash flows starting at time t = 1 In other words, “=NPV()” should only be used with future cash flows 15 NPV Pitfall #4: Including Sunk Costs Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 16 NPV Pitfall #5: Non‐Cash Expenses Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com 17 Case Study Critique: What’s wrong and how should it be corrected? Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com CASE STUDY Year 2014 2015 2016 2017 2018 Discount rate (inflation assumed 2.5%/year) 10.00% Plant and equipment 350,000 Research and Development 5,000 Excess capacity (for accounting purposes) 50,000 Total nonrecurring costs 355,000 0 50,000 0 0 0 Hardware engineering 25,000 25,000 Test and evaluation 35,500 55,000 Production 100,000 100,000 100,000 100,000 Assembly 15,000 15,000 15,000 15,000 Depreciation* 60,000 60,000 60,000 60,000 60,000 Management Program/Project management 103,500 103,500 103,500 103,500 103,500 Corporate executive officer salary 10,000 10,000 10,000 10,000 10,000 Overhead expenses allocated to program 8,500 8,500 8,500 8,500 8,500 Total ongoing costs 242,500 377,000 297,000 297,000 297,000 Benefits/Revenue 500,000 500,000 500,000 500,000 Net cash flow ‐355,000 ‐242,500 123,000 203,000 203,000 203,000 NPV (56,586) Internal Rate of Return 6.5% * Use IRS Depreciation schedule Form 9999‐D 18 Case Study Critique: What’s wrong and how should it be corrected? Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com CASE STUDY Real Year 2014 2015 2016 2017 2018 Discount rate (inflation assumed 2.5%/year) 7.32% Plant and equipment 350,000 Research and Development Excess capacity (for accounting purposes) Deleted Total nonrecurring costs 350,000 0 0 0 0 0 Hardware engineering 25,000 25,000 Test and evaluation 35,500 55,000 Production 100,000 100,000 100,000 100,000 Assembly 15,000 15,000 15,000 15,000 Depreciation* Deleted Management Program/Project management 103,500 103,500 103,500 103,500 103,500 Corporate executive officer salary Overhead expenses allocated to program Deleted Total ongoing costs 164,000 298,500 218,500 218,500 218,500 Benefits/Revenue 500,000 500,000 500,000 500,000 Net cash flow ‐350,000 ‐164000 201,500 281,500 281,500 281,500 NPV 309,885 Internal Rate of Return 25.0% * Use IRS Depreciation schedule Form 9999‐D 19 Case Study: Suggested Critiques Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com "Preliminary Engineering" is a sunk cost; not a relevant cash flow and should be omitted 20 Questions Presented at the 2013 ICEAA Professional Development & Training Workshop - www.iceaaonline.com • NATHAN HONSOWETZ • [email protected] • KEVIN SCHUTT • [email protected] 21.
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