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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 21 1

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Describe the importance of capital investments and the capital budgeting process Use the payback period and rate of return methods to make capital investment decisions Use the time value of money to compute the present and future values of single lump sums and annuities Use discounted cash flow models to make capital investment decisions

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe the importance of capital investments and the capital budgeting process 1 1 3

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Last chapter looked at recurring parallel options Took place in the same time sequence Revenues and expenses primarily 4 This chapter we remove that timing restriction Any time you want Revenues, expenses, and investments How do we compare return and investment if they come in different amounts at different times?

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Should we make the capital investment? 5 Should we buy new, or rebuild? Should we install solar panels? Should we open another store or open an online store? Should we start this new business?

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 6 Identify potential investmentsEstimate net cash inflows/outflowsAnalyze investment using method(s)Choose option(s)Post-audit to measure outcomes

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simple techniques The payback method (Simple) rate of return (ROR) Techniques using time value of money Present & future value of a single amount (lump sum) Present & future value of a payment stream (annuity) Net present value (NPV) Profitability index Internal rate of return (IRR) What we wont look at today Sensitivity analysis Monte Carlo analysis Other advanced computer models Our simple and TVM techniques cover virtually all of the analysis needs most of us are likely to ever need.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Operating income based on accrual accounting Contains noncash expenses Capital investments net cash inflows will differ from its operating income Cash inflows: Future cash revenue generated Future savings in ongoing cash operating costs Future residual value Cash outflows: Initial investment Ongoing operating costs, maintenance, repairs 8

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the payback and rate of return methods to make capital investment decisions 2 2 9

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Measures how quickly managers expect to recover their investment dollars The shorter the payback period, the more attractive the investment Used to screen capital investment choices May be the only tool in simple situations 10

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If the project provides equal annual returns, then use this formula: 11

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 12 Unequal annual net cash inflows Total net cash inflows until the amount invested is recovered

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider the following two investment options for the My Coffee: Sell Caffe Rent Caffe Machines Machines Initial investment$100,000$100,000 Year 1 net cash inflows$50,000$30,000 Year 2 net cash inflows $50,000$30,000 Year 3 net cash inflows $50,000$30,000 Year 4 net cash inflows $50,000 $30,000 Years 5-10 net cash inflows $0 $30,000 Based on the payback period. Which project would you prefer and why? Consider the following two investment options for the My Coffee: Sell Caffe Rent Caffe Machines Machines Initial investment$100,000$100,000 Year 1 net cash inflows$50,000$30,000 Year 2 net cash inflows $50,000$30,000 Year 3 net cash inflows $50,000$30,000 Year 4 net cash inflows $50,000 $30,000 Years 5-10 net cash inflows $0 $30,000 Based on the payback period. Which project would you prefer and why?

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Preston, Co. is considering buying a manufacturing plant for $1,100,000. They expect the plan to generate average annual cash inflows of $297,000. What is the payback period of this project? They impose a 6 year hurdle: should they buy? 14

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. So much better than nothing Emphasis on payback, not additional profits Easy story telling, good for sales Ignores cash flows after the payback period An experienced user can do well with it Requires human thought seat of the pants additional analysis 15

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. ROR measures the average accounting rate of return over the assets entire life Focuses on the operating income, from the financials Maximize reported profitability, not necessarily cash flows Formula Average annual operating income The assets total operating income over the course of its operating life divided by its lifespan Average amount invested Net book value at the beginning of the assets useful life plus the net book value at the end of the assets useful life divided by 2 16

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Preston, Co. is considering buying a manufacturing plant for $1,100,000. They expect the plan to generate average annual cash inflows of $297,000 for 6 years. They expect to salvage the obsolete factory for $550,000 after 6 years. What is the rate of return of this project? 17

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 18

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculating average annual operating income from asset 19

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculating rate of return If the company required a ROR of at least 20%, this project would be rejected 20

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider how Smith Valley Snow Park Lodge could use capital budgeting to decide whether the $13,500,000 Snow Park Lodge expansion would be a good investment. Assume Smith Valleys managers developed the following estimates concerning the expansion: Assume that Smith Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $1,000,000 at the end of its 10-year life. 21

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1. Compute the average annual net cash inflow from the expansion. Average cash received from each skier per day $ 236 Average variable cost of serving each skier per day (76) Average net cash inflow per skier per day $ 160 Number of additional skiers per day × 117 Average net cash inflow per day $ 18,720 Number of ski days per year × 142 Average annual net cash inflow per year $2,658, Compute the average annual operating income from the expansion. = Average annual net cash inflow depreciation = $2,658,240 $1,250,000 = $1,408,240 22

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the Smith Valley Snow Park Lodge expansion project in S Compute the payback period for the expansion project. Payback period = Amount invested / Expected annual net cash inflow = $13,500,000 / $ 2,658,240 = 5.1 years (Rounded to one decimal place) 23

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the Smith Valley Snow Park Lodge expansion project in S Calculate the ROR. 24 Accounting rate of return= Average annual operating income from investment Average amount invested = $2,658,240 $1,250,000 [$13,500,000 + $1,000,000] / 2 = 1,408,240 $ 7,250,000 =19.42% (Round to nearest hundredths)

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the time value of money to compute the present and future values of single lump sums and annuities

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Invested money earns income over time Timing of capital investments net cash inflows is important Two methods of capital investment using TVM The net present value (NPV) Internal rate of return (IRR) 26

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Principal (p)–amount of the investment Lump sum Single quantity of money Annuity Stream of equal installments at equal time intervals Number of periods (n) From the beginning of the investment until termination Interest rate (i)–annual percentage Simple interest Compound interest 27

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lets take a look at what those fancy tables do on the board! Watch closely as I turn $1 into $2! i=15%, N=5

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simple interest Interest calculated only on the principal amount Compound interest Interest is calculated on the principal and on all previously earned interest Assumes that all interest earned will remain invested and earn additional interest at the same interest rate Capital investments yield compound interest Assume compounding interest for rest of this chapter 29

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The value of an investment at different points in time 30

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simplify present and future value math Programmed into business calculators and spreadsheet programs See Appendix B for present and future factor tables: Lets play with the future value table first. 31

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lump sum Multiply amount by the factor number found in table Table based on interest rate and number of periods $10,000 invested for 5 periods at 6% 32 $10,000 X = $13,382 Differences due to table decimal places

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If you invested $1,000 today into a 6% fixed rate security, how much would it be worth in 50 years? Draw a time line indicating knowns and unknowns Identify table needed and go to it Look up the factor for the rate and time indicated Set up the formula and calculate Ask yourself if your answer makes sense 33

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lump sum Multiply amount by the factor found in table Table based on interest rate and number of periods $13,383 to be received in 5 periods at 6% 34 $13,382 X = $10,000 Differences due to table decimal places

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How much would you have to invest today so that you could buy a $10,000 car for cash 5 years from today? We earn 3% on our money. Draw a time line indicating knowns and unknowns Identify table needed and go to it Look up the factor for the rate and time indicated Set up the formula and calculate Ask yourself if your answer makes sense 35

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Future Value ? Present Value ? Annuity: A cash flow that occurs in identical amounts at repeating intervals. You could take each and every year and calculate present/future values for each year….. OR, you could recognize the annuity and take just one calculation using the annuity table $100$100$100$100$100$100

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If we Invest $2,000 at 6%, at the end of each year for 5 years, how much do we have at the end? 37 $2,000 X ,274.20

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How much do we need to squirrel away today, so we can pull $2,000 out to spend at the end of every year for 5 years? Assume 6% interest. 38 $2,000 X $8.424 Draw a time line indicating knowns and unknowns Identify table needed and go to it Look up the factor for the rate and time indicated Set up the formula and calculate Ask yourself if your answer makes sense $8,424

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How much do you need? Annual expenditure expectations Solve for balance at the beginning of retirement How are you going to get it there? Lump sum deposit now Annual retirement contributions 39

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use discounted cash flow models to make capital investment decisions

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Payback and ROR do not recognize time value of money Net present value (NPV) and internal rate of return (IRR) do recognize time value of money Both compare amount of investment with its expected net cash inflows Cash outflow for investment usually occurs now Cash inflows usually occur in the future Companies use present value to make the investment comparison, not future value 41

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. NPVthe net difference between the present value of the investments net cash inflows and the investments cost (cash outflows) Discount ratethe interest rate that discounts or reduces future amounts to their lesser value in the present (today). Discount rate uses the firms desired rate of return Based on cost of capital If present value of the investments net cash inflows exceeds the initial cost of the investment, then it is a good investment 42

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Buy a new welder for cash. Cost $10,000 Lease the welder for $1,500/year for 10 years Assume: Discount rate 10% Zero salvage Average welder life in our hands is 10 years.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Investment required: $250,000 Annual earnings of $50,000 You will own it for 20 years. You will then sell it for $1,000,000. Your cost of capital is 10% What is the NET present value of this project?

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Harley Davidson Purchase cost $25,000 Salvage value $17,000 Annual costs $500 more than Kawasaki. Kawasaki Purchase cost $12,000 Salvage value $1,000

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Assume you win the lottery Option #1: $1,000,000 now Option #2: $150,000 the end of each year for next ten years Option #3: $2,000,000 ten years from now Which option is the best? Use PV factors for single sum and annuities to find out Option #1 is $1,000,000 in your hand today Option #2 is an annuity, 10 payments Using PV annuity tables, assuming 8% 46 $150,000 x = $1,006, payments yield a present value of $1,006,515 and more than $1,000,000

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Assume you win the lottery Option #1: $1,000,000 now Option #2: $150,000 the end of each year for next ten years Option #3: $2,000,000 ten years from now Use PV factors for single sum to find out what option #3 is worth today 47 Option #3 $2,000,000 x.4632 = $ 926,400 Option #1 = $1,000,000 Option #2 = $1,006,515 Option #3 = $ 926,400 Option #2 is the highest of the three

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Your grandfather would like to share some of his fortune with you. He offers to give you money under one of the following scenarios (you get to choose): 1.$8,750 a year at the end of each of the next seven years. 2.$50,050 (lump sum) now. 3.$100,250 (lump sum) seven years from now. Calculate the present value of each scenario using a 6% discount rate. Which scenario yields the highest present value? Would your preference change if you used a 12% discount rate? 48

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculate the present value of each scenario using a 6% discount rate. Which scenario yields the highest present value? Would your preference change if you used a 12% discount rate? 49 Scenario #1 Present value=$ 8,750 × (Annuity PV factor, i = 6%, n = 7) =$ 8,750 × =$ 48,843 Scenario #2 Present value=$50,050 (since it would be received now) Scenario #3 Present value=$100,250 × (PV factor, i = 6%, n = 7) =$100,250 ×.665 =$ 66,666 Scenario #3 appears to be the best option. Based on a 6% interest rate, its present value is the highest.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Would your preference change if you used a 12% discount rate? 50 Scenario #1 Present value=$ 8,750 × (Annuity PV factor, i = 12%, n = 7) =$ 8,750 × =$ 39,935 Scenario #2 Present value=$50,050 (since it would be received now) Scenario #3 Present value=$100,250 × (PV factor, i = 12%, n = 7) =$100,250 ×. 452 =$ 45,313 Scenario #2 appears to be the best option. Based on a 12% interest rate, its present value is the highest.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Choose between two alternatives by comparing NPVs Consider these two projects: CD players generates higher total cash inflows DVRs generate cash flows sooner 51

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. CD players project generates equal cash flows Using Present Value of Annuity of $1, the NPV is: 52

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. DVR project has unequal net cash flows PV each inflow to find Net Present Value DVR project will generate net present value of $78,910 53

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Both projects, CD player and DVRs, had a positive NPV Both require the same investment amount Resources are limited, which project will be selected? To choose among the projects, compute the profitability index (present value index) 54

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Computes the number of dollars returned for every dollar invested Present value of net cash inflows Investment 55 Profitability index =

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If investment is expected to bring in even cash flows, use Present Value of Annuity (PVA) table If amounts are unequal: Present value of each individual cash flow is computed Use Present Value of $1 (PV) table 56

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Residual Values Cash inflows at the end of their useful lives Its present value is added to determine the total present value of the project(s) Discounted as a single lump sum 57

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Another discounted cash flow model for capital budgeting Rate of return a company can expect to earn by investing in the project The interest rate that will cause the present value to equal zero 58 Present value of the investments net cash inflows – Investments cost (Present value of cash outflows) $ 0

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The internal rate of return measures the real rate of return provided by the project. Higher return better Lower return worse 59

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

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NPV is easier to use. NPV Provides $$ results to compare: $$ pay the bills! IRR provides a comparable % return vs. strict dollar value. This can facilitate better evaluation of different scale/size/cost projects. Too much voodoo math?

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Profitability Present value of the project index Investment required = The Profitability Index factors in the investment size. This allows easier comparison amongst different size projects. The higher the profitability index, the more desirable the project. This provides the easily comparable result of IRR with most of the simplicity of NPV. The Profitability Index factors in the investment size. This allows easier comparison amongst different size projects. The higher the profitability index, the more desirable the project. This provides the easily comparable result of IRR with most of the simplicity of NPV.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Profitability Net Present Value index Investment required = The higher the profitability index, the more desirable the project. The higher the profitability index, the more desirable the project.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Steps for computing the IRR of an investment with equal periodic cash flows: 1.IRR is the interest rate that makes the cost of the investment equal to the present value of the investments net cash inflows 2.Plug into the equation any information we do know 3.Rearrange the equation and solve for the Annuity PV factor (i = ?, n = 5) 4.Find the interest rate that corresponds to this Annuity PV factor 64

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider Gregs CD-player project, which would cost $1,000,000 and result in five equal yearly cash inflows of $305, Investments cost = Amount of each equal net cash inflow X Annuity PV factor 2.$1,000,000 = $305,450 X Annuity PV factor (i = ?, n = 5) 3.$1,000,000 ÷ $305,450 = Annuity PV factor (i = ?, n = 5) $1,000,000 ÷ $305,450 = rounded to = Annuity PV factor (i = ?, n = 5)

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 66 Methods that Ignore the Time Value of Money

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 67 Methods that Incorporate the Time Value of Money

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider how Smith Valley Snow Park Lodge could use capital budgeting to decide whether the $13,500,000 Snow Park Lodge expansion would be a good investment. Assume Smith Valleys managers developed the following estimates concerning the expansion: Assume that Smith Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $1,000,000 at the end of its 10-year life. 68

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the Smith Valley Snow Park Lodge expansion project in S What is the projects NPV? Is the investment attractive? Why? 69 The expansion is attractive project because its NPV is positive. PV factor at 10% Net Cash Inflow Total Present Value Present value of annuity of equal annual net cash inflows for 10 years at 10%6.145 × $2,658,240$16,334,885 Present value of residual value.386 × $1,000, ,000 Total present value$16,720,885 Investment (13,500,000) Net present value of expansion$ 3,220,885

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to S21-2. Assume the expansion has no residual value. 1. What is the projects NPV? Is the investment attractive? Why? 70 Without a residual value, the expansion is still attractive project because its NPV is positive Annuity PV factor at i=12%, n= 12 Net Cash Inflow Total Present Value Present value of annuity of equal annual net cash inflows for 12 years at 12% × $2,658,240$16,334,885 Investment (13,500,000) Net present value of expansion$ 2,834,885

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to S Continue to assume that the expansion has no residual value. 1. What is the projects IRR? Is the investment attractive? Why? 71 Investment cost = Expected annual net cash inflows × Annuity PV factor (n=10, i = ?) $13,500,000=$2,658,240× Annuity PV factor (n = 10, i = ?) $13,500,000 = Annuity PV factor (n = 10, i = ?) $2,658, = Annuity PV factor (n = 10, i = ?) The IRR is somewhere between %. The project attractive since it will earn a higher return than the companys 10% hurdle rate.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Capital budgeting is planning to invest in long-term assets in a way that returns the greatest profitability to the company. Capital rationing occurs when the company has limited assets available to invest in long- term assets. The four most popular capital budgeting techniques used are payback period, rate of return (ROR), net present value (NPV), and internal rate of return (IRR). 72

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The payback period focuses on the time it takes for the company to recoup its cash investment, but ignores all cash flows occurring after the payback period. Because it ignores any additional cash flows (including any residual value), the method does not consider the profitability of the project. The ROR, however, measures the profitability of the asset over its entire life using accrual accounting figures. It is the only method that uses accrual accounting rather than net cash inflows in its computations. The payback period and ROR methods are simple and quick to compute, so managers often use them to screen out undesirable investments. However, both methods ignore the time value of money. 73

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Invested money earns income over time. This is called the time value of money, and it explains why we would prefer to receive cash sooner rather than later. The time value of money means that the timing of capital investments net cash inflows is important. The cash inflows and outflows are either single amounts or annuities. An annuity is equal cash flows over equal time periods at the same interest rate. Time value of money tables in Appendix B help us to adjust the cash flows to the same time period (i.e., today or the present value, or a future date or the future value). 74

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The NPV is the net difference between the present value of the investments net cash inflows and the investments cost (cash outflows), discounted at the companys required rate of return (hurdle) rate. The investment must meet or exceed the hurdle rate to be acceptable. The IRR is the interest rate that makes the cost of the investment equal to the present value of the investments net cash inflows. Capital investment (budgeting) methods that consider the time value of money (like NPV and IRR) are best for decision making. 75

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 76

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 77 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

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