Professional Documents
Culture Documents
Capital Budgeting
and Other Time
Value of Money
Applications
Richard E. McDermott, Ph.D.
$200,000
Costs and expenses
$132,000
26,000
22,000
180,000
20,000
7,000
$ 13,000
Net income
$13,000
Net income
Add: Depreciation expense
$13,000
26,000
Net income
Add: Depreciation expense
Cash flow
$13,000
26,000
$39,000
$130,000
$39,000
3.33 years
Review Question
A $100,000 investment with a zero scrap value has an 8-year life.
Compute the payback period if straight-line depreciation is used and net
income is determined to be $20,000.
a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.
Review Question
A $100,000 investment with a zero scrap value has an 8-year life.
Compute the payback period if straight-line depreciation is used and net
income is determined to be $20,000.
a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.
Calculation of answer:
First calculate depreciation:
$100/000/8 years = $12,500
Add depn to income to get net cash flow:
$20,000 + $12,500 = $32,500
Divide investment by yearly cash flow to
get payback period:
$100,000/$32,500 = 3.08 years.
A Little Theory . . .
Assume we invest a lump
sum of $100 in time period
zero.
Money
$300
$200
$100
Time
A Little Theory . . .
We let it grow for three
years.
Money
$120
$100
Time
A Little Theory . . .
These figures can be calculated using Excel.
Money
Again we are talking about lump sums!
$133.10
$130
$120
$100
Time
Excel Worksheet
Select Formulas
Select Financial
Excel Worksheet
Excel Worksheet
This box will appear on your screen.
Excel Worksheet
Notice that we put nothing in the Pmt
box since the $100 is the only deposit.
Excel Worksheet
Hit Ok.
The future value of
$100 for 3 periods at
10% per period is
$133.10.
Another Method
One can also type financial commands into
Excell.
The command for future value is =fv
Enter =fv( and you get the following on
your screen
FV(rate,nper,pmt,[pv],[type])
Entering the values
=fv(.10,3,0,100,0)
The answer given is ($133.10)
Calculation
This time
select PV from
the drop down
menu.
To Illustrate . . .
The first year we make a
payment of $100. That amount
grows with interest until we
make a second payment which
in turn grows with interest until
we make a third payment.
Money
New
Axis
$331
$300
$200
$100
Time
Select Formulas
Select Financial
Practice Problem
Things to Be Aware of
Make sure you pay attention to the fact
that the money is deposited in savings
monthly.
The pop-up box, interest, periods, and
payments must all be consistent.
The interest rate will not be .08 but .
08/12 months = .006667.
The number of periods will be 30 years x
12 months = 360.
Calculation
Pop-up Box
PV and FV Functions
With the PV and FV functions, we can
combine and annuity and a lump sum
calculation.
For example, assume you have $25,000 to
deposit in the bank today at 6%.
Then for the next ten years you will
deposit $5,000 a year at 6%.
How much will you have (what will the
future value be) at the end of ten years?
The answer is . . .
$70,339.57
Why do we care?
Because this is one way of valuing a
business!
Why We Care
Valuing a Business
Valuing a Business
Solution
Drag and drop the cash flows from the Excel Spreadsheet into the
values box.
Example
Example
Time
Period Cash Flow
0 -2000000
1
-40000
2
-20000
3
-10000
4
100000
5
400000
6
600000
7
800000
8 1000000
9 1500000
10 1800000
In Excel the calculation is a two step process. First we use NPV to determine the net
present value of cash flows in periods 1 through 10. Then we add the present value of
$2.000.000 today (which of course is $2,000,000) to get the net present value.
Lets do it!
Solution
Solution
Solution
Solution
Time
Period Cash Flow
0 -2000000
1
-40000
2
-20000
3
-10000
4
100000
5
400000
6
600000
7
800000
8 1000000
9 1500000
10 1800000
Select
formulas
Solution
Select
Insert
Function
Select IRR
Solution
Although it is hard to see using PowerPoint, when I drag and drop the values
into the values box, I do include the value for time period 0.
The answer you should receive is 14.6957%!
Additional Considerations
Additional Considerations
To avoid rejecting projects that actually should be
accepted, two possible approaches are suggested:
1. Calculate net present value ignoring intangible
benefits. Then, if the NPV is negative, ask
whether the intangible benefits are worth at least
the amount of the negative NPV.
2. Project rough, conservative estimates of the
value of the intangible benefits, and incorporate
these values into the NPV calculation.
Profitability Index
Profitability Index
Assume we are evaluating two projects, projects A and
B.
The initial investment of Project A is $40,000, and the
initial investment of Project B is $90,000.
Also assume that we have calculated the present value
of net cash flows for each project.
The present value of Project A is $58,112, and the
present value of Project B is $110,574.
What is the profitability index of each project?
Profitability Index
Present Value of Net Cash
Flows
Initial Investment
=
Project A
Present Value
of Net Cash
Flows
$58,112
Profitability
Index
Project B
$110,574
Initial Investment
Project A
Present Value
of Net Cash
Flows
Divide by
Initial
Investment
Profitability
Index
Profitability
Index
Project B
$58,112
$110,574
$40,000
$90,000
1.4528
1.2286
Profitability Index
Review Question
Assume Project A has a present value of net cash inflows of $79,600
and an initial investment of $60,000. Project B has a present value of
net cash inflows of $82,500 and an initial investment of $75,000.
Assuming the projects are mutually exclusive, which project should
management select?
a.
Project B.
b. Project A or B.
c. Project A.
d. There is not enough data to answer the question.
Review Question
Assume Project A has a present value of net cash inflows of $79,600
and an initial investment of $60,000. Project B has a present value of
net cash inflows of $82,500 and an initial investment of $75,000.
Assuming the projects are mutually exclusive, which project should
management select?
a.
Project B.
b. Project A or B.
c. Project A.
d. There is not enough data to answer the question.
Review Question
Bear Company computes an expected annual net income from an
investment of $30,000. The investment has an initial cost of $200,000
and a terminal value of $20,000. Compute the annual rate of return.
a. 15%.
b. 30%.
c. 25%.
d. 27.3%.
Review Question
Bear Company computes an expected annual net income from an
investment of $30,000. The investment has an initial cost of $200,000
and a terminal value of $20,000. Compute the annual rate of return.
a. 15%.
b. 30%.
c. 25%.
d. 27.3%.
Review Problem 1
Review Problem 1
Review Problem 2
Jacks Custom Manufacturing Company is
considering three new projects, each requiring
an equipment investment of $21,000.
Each project will last for 3 years and produce
the net annual cash flows shown below:
Year
AA
BB
CC
$7,000
$9,500
$13,000
9,000
9,500
10,000
15,000
9,500
11,000
Total
$31,000
$28,500
$34,000
Review Problem 2
Review Problem 2
Lets do project AA first:
The first years cash flow is $7,000 as shown on
the chart.
The second years cash flow is $9,000 which
brings the cumulative cash flow to $16,000.
At the end of the third year we only need
$5,000 to reach payback.
It takes $5,000/$15,000 = .33 of a year to get
this cash.
The payback period, therefore, is 2.33 years
Review Problem 2
Review Problem 2
Review Problem 2
Review Problem 3
Mane Event is considering a new hair salon in
Pompador, California.
The cost of building a new salon is $300,000.
The new salon will normally generate annual
revenues of $70,000 with annual expenses
(excluding depreciation) of $40,000.
At the end of 15 years, the salon will have a
salvage value of $75,000.
Review Problem 3
Okay, since depreciation is included in the
expenses, we can expenses as given from
revenues to get accounting income.
Remember, we need accounting income for
annual rate of return, not cash flows as with
NPV.
Annual income is $70,000 - $40,000 = $30,000.
The average investment is calculated using the
following formula:
(Investment + Salvage Value)/2
Review Problem 3
Review Problem 4
Review Problem 4
Review Problem 4
Review Problem 4
Review Problem 4
Review Problem 4
Review Problem 4
Fee revenues
11 x $125 x 52
Annual Net
Income
Annual
Cash Flow
$71,500
$71,500
Review Problem 4
Fee revenues
Annual Net
Income
Annual
Cash Flow
11 x $125 x 52
$71,500
$71,500
given
60,000
60,000
Expenses
Salaries
Review Problem 4
Annual Net
Income
Annual
Cash Flow
11 x $125 x 52
$71,500
$71,500
Salaries
given
60,000
60,000
given
6,000
6,000
Fee revenues
Expenses
Review Problem 4
Annual Net
Income
Annual
Cash Flow
11 x $125 x 52
$71,500
$71,500
Salaries
given
60,000
60,000
given
6,000
6,000
($20,000/5)
4,000
Fee revenues
Expenses
Depreciation
Review Problem 4
Annual Net
Income
Annual
Cash Flow
11 x $125 x 52
$71,500
$71,500
Salaries
given
60,000
60,000
given
6,000
6,000
($20,000/5)
4,000
70,000
66,000
Fee revenues
Expenses
Depreciation
Total expenses
Review Problem 4
Annual Net
Income
Annual
Cash Flow
11 x $125 x 52
$71,500
$71,500
Salaries
given
60,000
60,000
given
6,000
6,000
($20,000/5)
4,000
70,000
66,000
Fee revenues
Expenses
Depreciation
Total expenses
Net Income
$1,500
Review Problem 4
Annual Net
Income
Annual
Cash Flow
11 x $125 x 52
$71,500
$71,500
Salaries
given
60,000
60,000
given
6,000
6,000
($20,000/5)
4,000
70,000
66,000
Fee revenues
Expenses
Depreciation
Total expenses
Net Income
Cash flows
$1,500
$5,500
Review Problem 4
Review Problem 4
Review Problem 4
Review Problem 4
Remember, the Net Present Value is
calculated by netting the present value of
the capital investments with the present
value of the future cash in-flows.
So NPV = $20,849 - $20,000 = $849
Note: The PV is positive, so we made over
10%--our minimum required rate of
return.
Review Problem 4
Mortgages
Mortgage Calculation
Select Formulas
Select Financial
Select PMT (for payment)
Pop-up Window
The PV (present value) is
$100,000, the amount of the
mortgage.
The FV (future value) is
zero since the mortgage will
be paid off at the end of 360
periods.
$1,028.61
Less interest
Amount applied to principal.
1,000.00
$28.61
Amortization Table
Payments in First 12 Months
Feb
$99,971.39
$28.90 $999.71
1
9
$1,028.6
$99,913.3
Mar
$99,942.49
$29.19 $999.42
1
0
$1,028.6
$99,883.8
Apr
$99,913.30
$29.48 $999.13
1
2
$1,028.6
$99,854.0
May
$99,883.82
$29.77 $998.84
1
5
$1,028.6
$99,823.9
Jun
$99,854.05
$30.07 $998.54
1
8
$1,028.6
$99,793.6
Jul
$99,823.98
$30.37 $998.24
1
1
What if when we pay the first payment
of $1,028.61, we enclose an $99,762.9
additional amount
$1,028.6
for Aug
$99,793.61
$30.67
$997.94
$28.90? Will jump from Januarys payment
additional
1 to Marchs payment. For and 4
$28.90 we will never make that $1,028.61
payment.
$1,028.6
$99,731.9
Sep
$99,762.94
$30.98 $997.63
1
6
$1,028.6
$99,700.6
a bad investment! $99,731.96
Pay $28.90, save
$1,028.61!
NotOct
$31.29 $997.32
1
7
$1,028.6
$99,669.0
Nov
$99,700.67
$31.60 $997.01
1
7
Year Month
Amortization Table
Payments in First 12 Months
Feb
$99,971.39
$28.90 $999.71
1
9
$1,028.6
$99,913.3
Mar
$99,942.49
$29.19 $999.42
1
0
$1,028.6
$99,883.8
Apr
$99,913.30
$29.48 $999.13
1
2
$1,028.6
$99,854.0
May
$99,883.82
$29.77 $998.84
1
5
$1,028.6
$99,823.9
Jun
$99,854.05
$30.07 $998.54
1
8
$1,028.6
$99,793.6
Jul
$99,823.98
$30.37 $998.24
1
1
What if we pay the sum of the remaining
principal payments for the$99,762.9
year (red)? This
$1,028.6
totals
Aug
$99,793.61
$30.67
$997.94
to $334.24. Just include that with the
1 first check of $1,028.61 and you
4 will skip so
that next month instead of making the
February payment, you will now
be on the January
$1,028.6
$99,731.9
2008
Sep
$99,762.94
$30.98
$997.63
payment, a savings of $10,980.47 in interest.
1
6
$1,028.6
$99,700.6
Oct
$99,731.96
$31.29 $997.32
1
7
$1,028.6
$99,669.0
Nov
$99,700.67
$31.60 $997.01
1
7
Year Month
Number of Months
Payment
Total Paid
15
180
$1,200.17
$219,090.60
20
240
$1,101.09
$264,261.60
30
360
$1,028.61
$370,299.60
40
480
$1,008.50
$484,080.00
50
600
$1,002.56
$601,536.00
100
1,200
$1,000.01
$$1,200,012.00
The difference in the monthly payment from cutting your length of mortgage in half is only
$171.56.
However, the difference in the amount you wind up paying for the house is $151,209!
Number of Months
Payment
Total Paid
15
180
$1,200.17
$219,090.60
20
240
$1,101.09
$264,261.60
30
360
$1,028.61
$370,299.60
40
480
$1,008.50
$484,080.00
50
600
$1,002.56
$601,536.00
100
1,200
$1,000.01
$$1,200,012.00
I have actually hear (on a radio interview) bankers complaining about how hard it is for
young people to make mortgage payments with higher interest rates (I have seen 17%
In my lifetime) and advocate going to 40 or 50 year mortgages.
Who do you think that proposal is designed to benefit. The poor young couples or the
bankers?
Objective
Dream Home
Freds Decision
Franks Decision
Frank is a little more patient.
He has the same payment to make on a
house.
He takes his computer and determines
how much house he can buy with a 10 year
mortgage for
$1,834.41.
He an buy a modes
$151,195 home.
Investment
Another Illustration
New Question
How much do you have to deposit monthly at
10% to have $1,000,000 when you retire?
Age 25--$158.12
Age 30--$161.69
Age 35--$446.07
Age 40757.49
Age 50--$2,417.23
Age 55--$4,887.39
Last Example
Homework
Exercise 12-2
Jacks Custom Manufacturing Company is
considering three new projects, each requiring
an equipment investment of $21,000.
Each project will last for 3 years and produce
the net annual cash flows shown below:
Year
AA
BB
CC
$7,000
$9,500
$13,000
9,000
9,500
10,000
15,000
9,500
11,000
Total
$31,000
$28,500
$34,000
Exercise 12-2
Exercise 12-2
Lets do project AA first:
The first years cash flow is $7,000 as shown on
the chart.
The second years cash flow is $9,000 which
brings the cumulative cash flow to $16,000.
At the end of the third year we only need
$5,000 to reach payback.
It takes $5,000/$15,000 = .33 of a year to get
this cash.
The payback period, therefore, is 2.33 years
Exercise 12-2
Exercise 12-2
CC
$
13,000.00
9,500.00
10,000.00
3 15,000.00 9,500.00
11,000.00
Present value of
investments
Net present values of investments
Best option
Exercise 12-6
Mane Event is considering a new hair salon in
Pompador, California.
The cost of building a new salon is $300,000.
The new salon will normally generate annual
revenues of $70,000 with annual expenses
(excluding depreciation) of $40,000.
At the end of 15 years, the salon will have a
salvage value of $75,000.
Exercise 12-6
Okay, since depreciation is included in the
expenses, we can expenses as given from
revenues to get accounting income.
Remember, we need accounting income for
annual rate of return, not cash flows as with
NPV.
Annual income is $70,000 - $40,000 = $30,000.
The average investment is calculated using the
following formula:
(Investment + Salvage Value)/2
Exercise 12-6
The End