Time Value of Money

and
Introduction to
Capital Budgeting

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 Concept of
The

Capital
Budgeting
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 Capital Budgeting

Capital Budgeting
Making long-term asset purchase decisions

Capital: Financing obtained by a business in order to buy

the assets that it needs
• In this case, the “capital” mentioned is the permanent financing, the
interest-bearing loans and the equity.

Budgeting: Numerical, Financial Planning

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 Importance of
Capital Budgeting
Large initial outlay. If a company makes
mistakes in its large spending decisions, it will
struggle to survive.
Potential long-term impact on earnings. Long-
term assets are with you for a LONG time.
Mistakes will punish you year after year.
Difficult to reverse course. Difficult to sell and
replace long-term assets.

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 Uses of
Capital Budgeting
Screening
Is the purchase of this long-term asset a good
idea?

Ranking
Is the purchase of this long-term asset the
BEST way for us to spend our money and
time?
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 Time Value of Money

Would you prefer to receive

• $100 today or
• $100 one year from now?

$100 ?? $100 ??
|---------------------------------------------------------------------------------------------|
Today One Year

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 Interest
The Cost of Using Money

If the interest rate is 10%,

receiving $100 today is the same as
receiving $110 one year from now.

10%
$100 $110
|---------------------------------------------------------------------------------------------|
Today One Year

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 Discounting
If the interest rate is 10%,
receiving $110 one year from now is the
same as receiving $100 today.
10%
$100 $110
|---------------------------------------------------------------------------------------------|
Today One Year
DISCOUNTING: Explicitly and mathematically using the
time value of money to make long-term decisions.

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 Discounting Cash Flows

Project A
• Generates a cash inflow of $100,000 at the end of one
year.

Project B
• Generates a cash inflow of $50,000 at the end of each
year for the next two years.

For which Project would you pay more? Note:

The appropriate interest rate is 10%.
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 Discounting Cash Flows

Discounted Value (Present Value) =

$90,910

Discounted Value
(Present Value) =

$86,775
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 Present Value of
CASH OUTFLOWS

Purchase of a drill press

Cash cost $8,000
Trade-in allowance 500
Maintenance per year for 5 years 400

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 Present Value of
CASH OUTFLOWS
Purchase of a drill press
Cash cost $8,000
Trade-in allowance 500
Maintenance per year for 5 years 400
=================================================================

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 The Present Value
of an Annuity -- CALCULATOR
How much should you pay today in place of
paying $400 at the end of each year for the next
5 years if the interest rate is 12%?
N is the number of periods involved -- 5
I is the interest rate per period -- 12
PV is the present value of the cash flows
PMT is the amount of a series of
equal payments made each period -- 400
FV is the future value of the cash flows
Push “PV” to see present value of $1,441.910481

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 The Present Value
of an Annuity -- EXCEL
How much should you pay today in place of
paying $400 at the end of each year for the next
5 years if the interest rate is 12%?
PV Excel function
Excel Label Your Input
Rate .12
Nper 5
Pmt 400
Fv
Type

PV = $1,441.910481

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 Present Value of
CASH INFLOWS

Purchase of a drill press

Cash revenue per year for 5 years $2,500
Cash salvage value at end of 5 years 750

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 Present Value of
CASH INFLOWS
Purchase of a drill press

Cash revenue per year for 5 years $2,500

Cash salvage value at end of 5 years 750
=================================================================

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 NET Present Value of
CASH OUTFLOWS and INFLOWS

NET PRESENT VALUE: $9,438 - $8,942 = $496

DECISION?
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 Capital Budgeting

Capital Budgeting
Making long-term asset purchase decisions

Capital: Financing obtained by a business in order to buy

the assets that it needs
• In this case, the “capital” mentioned is the permanent financing, the
interest-bearing loans and the equity.
Budgeting: Numerical, Financial Planning

Don’t forget the TIME VALUE OF MONEY.

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NONDISCOUNTED
Capital Budgeting
Techniques
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 4 Common
Capital Budgeting Techniques

• Payback method
• Unadjusted rate of return method
• Net present value method (NPV)
• Internal rate of return method (IRR)

Payback and Unadjusted Rate of Return do

NOT explicitly include the TIME VALUE OF
MONEY.
“Nondiscounted” techniques.
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 4 Common
Capital Budgeting Techniques

• Payback method
• Unadjusted rate of return method
• Net present value method
• Internal rate of return method

Why use an unsophisticated “nondiscounted

technique”?
• VERY easy to use
• Intuitive

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 Payback Method

How LONG until we get our money back?

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 Payback Method Example
Buying a Computer/Printer System

Initial cost of computer/printer system $1,500

Net cash inflow per month 100

Payback Period

Required repayment time: 18 months → GOOD!

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 EXAMPLE: Using the
Payback Method
$50,000 initial cost
---------------------------------------
$10,000 cash inflows per year

Is a 5-year payback period good?

Scenario 1: Project is an investment in an office building. The cash
inflows will come from annual rent payments to be received.
Scenario 2: Project is an investment in a Web-based order tracking
system that is expected to save $10,000 each year in order tracking costs.

Look at the LIFE of the asset and the RISKINESS of the cash inflows.

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 Payback Method
Strengths and Weaknesses

Strengths
• VERY easy to use
• Intuitive

Weaknesses
• Measures investment recovery time, not
overall profitability
• Ignores the time value of money
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 Unadjusted Rate of Return

Accounting return on initial investment

(VERY similar to return on investment, ROI)

Unadjusted for what?

For the time value of money.
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 Unadjusted Rate of Return Example
Buying Canning Machinery

Initial cost of canning machinery $215,000

Increase in annual revenues 51,500
Machinery life 10 years
==========================================================
Increase in annual net income
Revenues $51,500
Depreciation expense ($215,000 ÷ 10 years) (21,500)
Increase in annual net income $30,000

Unadjusted Rate of Return

Increase in net income / Initial cost
$30,000 / $215,000 = 14.0%
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 EXAMPLE: Using the

Unadjusted Rate of Return

Unadjusted Rate of Return

Increase in net income / Initial cost
$30,000 / $215,000 = 14.0%
======================================
Compare
the 14.0% unadjusted rate of return to the
HURDLE RATE (minimum acceptable return)

Think of the HURDLE RATE as the return that can be earned on other
available investments.
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 Unadjusted Rate of Return
Strengths and Weaknesses

Strengths
• VERY easy to use
• Intuitive

Weaknesses
• Ignores the time value of money
• Based on accrual accounting rather that
CASH FLOWS
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 Discounted
Capital Budgeting
Techniques:
NPV
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 4 Common
Capital Budgeting Techniques

• Payback method
• Unadjusted rate of return method
• Net present value method (NPV)
• Internal rate of return method (IRR)

NPV and IRR explicitly include the TIME

VALUE OF MONEY.
“Discounted” techniques.

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 NPV and IRR

NPV
• Compute the present value of all cash inflows and outflows and add
them together. This is the net present value (NPV).
• Accept the project if the NPV is greater than zero.

IRR
• Compute the interest rate that makes the present value of the cash
inflows equal to the present value of the cash outflows.
• Accept the project if the internal rate of return (IRR) is greater than a
predetermined hurdle rate.

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 Selecting a Discount Rate

There are two ways to think of this choice of

the correct discount rate.
1. Use the interest rate that can be earned
on comparable investments. This is an
OPPORTUNITY COST approach.
2. Use the weighted-average cost of
acquiring the funds to finance the project.
This is an OUT-OF-POCKET COST approach.

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 Selecting a Discount Rate
Weighted-Average Cost of Capital (WACC)

There is a cost, either explicit or implicit, associated with each source of

financing.
• Cost of debt. Interest rate that must be
paid on the debt.
• Cost of new equity. The new investors
expect a return on their investment.
• Cost of retained earnings. The
shareholders expect some return on the
profits that are retained in the business.

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 Example
Weighted-Average Cost of Capital (WACC)

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 Selecting a Discount Rate
Adjusting for Risk

You have to PAY people to get

them to accept risk.
• Investors demand a HIGHER return for
more risky projects.
• Investors will accept a LOWER return for
less risky projects.

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 Selecting a Discount Rate

Caution!!
Selecting the appropriate risk-adjusted
discount rate to use in evaluating a capital
budgeting project is VERY DIFFICULT.
• 2% or 11% ???
• 10.0000% !!??!!
This is a major topic of study in the field of
FINANCE.
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 Net Present Value

1. Estimate the amount and timing of all cash flows.

2. Evaluate the riskiness of the cash flows; determine an
appropriate discount rate.
3. Compute the present values of all the expected cash
inflows and outflows.
4. Compute the NET present value (cash inflows minus cash
outflows).
5. Make a decision.
• If NPV > 0, yes!
• If NPV < 0, no!
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 Net Present Value
MBK Truck Example

Step 1 and Step 2 (amount, timing, and riskiness)

Cost of the new truck $18,000
Annual cash savings for 4 years 5,625
Salvage value at end of 4 years 1,800

Discount rate 10%

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 Net Present Value
MBK Truck Example

Step 3 (compute present values)

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 Net Present Value
MBK Truck Example

Step 4 (compute net present value)

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 Net Present Value
MBK Truck Example

Step 5 (Decision: Positive NPV means BUY IT)

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 Net Present Value
MBK Truck Example

What is the meaning of the $1,060 NPV?

• A positive NPV project earns a normal rate of return plus some extra.
• A negative NPV project earns less than a normal rate of return.

NPV is the amount by which the value of the entire

company changes the instant that the decision is
made to go forward with the project.

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 Net Present Value
Least-Cost Decision

Some long-term projects are necessary

to satisfy some requirement.
• Regulatory requirement
• Commitment to employees
• Hey, a person has to have a place to live!

In these cases, the decision rule is to choose the alternative

that has the LEAST NEGATIVE NPV.

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 Least-Cost Decision
New England Steel

Pollution-Control Device
Alternative 1
• Spend $1,000,000 immediately.

Alternative 2
• Spend $200,000 immediately.
• Spend an additional $125,000 each year for 10 years.

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 Least-Cost Decision
New England Steel

Pollution-Control Device
Alternative 2

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 Least-Cost Decision
New England Steel

Decision?
Alternative 1
• NPV = negative $1,000,000
Alternative 2
• NPV = negative $906,275

Choose Alternative 2.
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 Ivy Drive Financing

$300,000 Investment Property

25% Down Payment

75% Financed (30-year fixed mortgage)

Two Choices of Interest Rate:

1) 4.875% and pay $3,200 financing fee
2) 5.125% and no fee

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 Ivy Drive Financing

Calculate:

1) Monthly difference in mortgage

2) Payback Period
3) Which do you choose???

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 Ivy Drive Financing

Calculate:

1) $1,190.72 vs. $1,225.10

2) $3,200/$34.38 = 93.08 months (7.75
years)
3) Which do you choose???

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 Ivy Drive Financing

Other factors:

1) How long will you hold the

property?
2) Can you refinance?

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