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BY: Jae Kierstin Carreira PRESENTATION FOR COMPANY X 1

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PART B1 Identify what the correct net cash flow for the second year would be if all expenses were as described but there was no depreciation costs. Here is what we know already: Year two Net Cash Flow with depreciation Expected annual sales of new product Expected annual costs of new product cash expenses depreciation expenses Income before taxes Income tax at marginal rate Net income Net annual cash flow for years shown 3,170,000 2,400,000 380,000 390,000 124,800 265,200 645,200 2

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Year two Net Cash Flow with NO depreciation 3,170,000 2,400,000 380,000 770,000 246,400 523,600 You will notice that our net annual cash flow for year two is lower when we do not apply the depreciation back to the net income. Year two annual cash flow with depreciationYear two cash flow with NO depreciation $645,200$523,600 Expected annual sales of new product Expected annual costs of new product cash expenses depreciation expenses Income before taxes Income tax at marginal rate Net income Net annual cash flow for years shown A difference of $121, 600 in annual cash flow. 3

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PART B1a What is the impact of depreciation on net cash flow for year 2? Applying depreciation reduces the amount you pay in taxes because it reduces your taxable income. Therefore, depreciation affects cash flow by reducing the amount of cash a business must pay in income taxes. Income before taxes Income tax at marginal rate Net income 390,000 124,800 265,200 770,000 246,400 523,600 As you can see above, not taking depreciation will result in Company D paying $121,600 additional in taxes. For Example: Y2 with depreciationY2 with NO depreciation 4

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PART B2 The time value of money Before we can address a decision process for Net Present Value (NPV) and Internal Rate of Return (IRR) we must first understand the time value of money. In our case we will use the time value of $1. A very simple explanation of this concept is to say that a dollar today is worth more than a dollar in the future because you can invest your dollar today and make money from it, this is called interest. Invested money that earns income over time is called “time value of $1”. (Horngren et al, 2008 ) There are three factors you MUST know to figure time value of $1. 1.Principal amount (how much you are investing) 2.Number of periods (how long in time is your investment) 3.Interest rate (how much is this investment going to cost you) There are two methods of capital investment analysis that utilize the time value of money; Net Present Value (NPV) and Internal Rate of Return (IRR). We will discuss those and how they apply to our scenario next. 5

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NET PRESENT VALUE Net present value is the net difference between the present value of the investments net cash inflows and the investments costs (cash outflows) (Horngren, Harrison Jr., and Oliver, 2008). We discount the net inflows using the required rate of return which in this case 12%. This method is one of the two methods of analysis that uses the time value of money. For each year you find the PV factor for 12% return and multiply it by the cash flow. Next you need to add up all of the Present values and then subtract total investment and building restoration costs. Our figures are represented on the next slide. Example of a PV chart 6

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PART B2 (continued) 645,200 624,800 611,200 801,600 300,000 60,000 (150,000) 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 576,164 512,224 444,858 397,373 346,550 309,878 362,323 323,846 121,200 24,240 (60,600) (3,400,000) (39,944) Net Present Value (NPV)= -$39,944 Cash Flows: 12% PV Factors Present Value Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Working Capital Return Salvage Return Building restoration costs Total Investment Net Present Value 7

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PART B2 Based on the NPV analysis in part A2, make a recommendation to entrepreneur D regarding what decision to make. Net Present Value (NPV)= -$39,944 I recommend that Entrepreneur D does NOT invest in this endeavor based on the decision rule as follows: Decision rule for NPV: If the Net Present Value is positive – Invest. If the Net Present Value is negative – DO NOT invest. Since our NPV is negative, we are not recommending this as a viable investment option. 8

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PART B2a Explain why your recommendation is an appropriate action: I am making the recommendation to NOT invest because the NPV is -39,944, a negative number. This means that the total investment will be more than the total sales over the time frame that the entrepreneur intends to operate. 9

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INTERNAL RATE OF RETURN Internal rate of return is the second method of capital investment analysis that utilizes the time value of money. The IRR is the rate of return on discounted cash flow a company can expect to earn by investing in a project. The IRR is the interest rate that makes the cost of investment equal the present value of the investments net cash flow (Horngren et al, 2008 ). 10

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PART 3 Based on the IRR analysis, what is your recommendation to entrepreneur D? Based on the following information I am recommending again, that Entrepreneur D does NOT invest in this venture, as the IRR rate is 11.680%, which is below his required rate of return of 12%. Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 + Working Capital + Salvage - Remodeling Internal Rate of Return using excel 11

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PART 3a Explain why this is an appropriate action. Entrepreneur D has set a required return rate for this project of 12%. The IRR as indicated on the previous slide is 11.680%, which is under his requirement of 12%. According to the decision rule for IRR which states: If the IRR exceeds the required rate of return – invest If the IRR is less than the required rate of return – do NOT invest Clearly, Entrepreneur D should NOT invest as he is not making his 12% return. 12

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PART 4 Explain why the accounting rate of return on this project is different from the internal rate of return for the same capital investment. The percentages of these two methods of analysis are different because they are using the numbers differently. The internal rate of return (IRR) focuses on cash flow and utilizes discounted cash as well as factoring in working capital, salvage and remodeling costs whereas ARR does not. The accounting rate of return (ARR) measures the average rate of return over an assets lifetime. It focuses on the operating income instead of the net cash flow (Horngren et al, 2008 ) and does not utilize the time value of money in it’s equation. A side by side comparison is next: 13

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PART 4 (continued) Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 + Working Capital + Salvage – Remodeling Internal Rate of Return using excel Internal Rate of Return Accounting Rate of Return For IRR we are using net cash flow in our calculations.For ARR we are using net income in our calculations. Initial investment = 1,580,000 (including salvage value) Accounting Rate of Return Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total Net Income This is the main reason we end up with a different percentage between IRR and ARR. 14

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PART 5 Explain the relative significance of the unadjusted payback period. Some disadvantages of this method are: It focuses only on time, not profitability It ignores cash flows happening after the payback period. Some advantages of this method include: This method is quick and easy Works well for short term projects Is a good screening device when all other factors are the same. The payback period method should not be used as a sole criterion for deciding on an investment opportunity. As stated above, it does not give you a full picture of the potential of a given project. You will only be able to ascertain how long it will take to earn back your investment. You will not be able to see the cash flows following the payback period, therefore you will not be able to make a fully informed decision on the profitability of the project. Now, let’s see what might be a better alternative to the above… 15

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PART 5 (continued) I would recommend using a combination of the payback period, net present value and the internal rate of return to determine the feasibility of an investment. I would use the payback period first to see if the time it takes to pay back the investment is reasonable or not. Next, I would utilize the NPV, which gives you a very clear idea given your constraints whether or not it is a financially sound investment. Does your project have a positive or negative NPV? Finally, the IRR will tell you if your investment will make back the predetermined required rate of return. Is it above or below the WACC? 16

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PART 6 Weighted Average Cost Of Capital The weighted average cost of capital is the cost of borrowing money. It is the minimum that a company must make in return to satisfy the lenders, owners and security holders (Wikipedia, 2013). The WACC is calculated considering the relative weights of each component of the capital structure (Wikipedia, 2013). It is displayed as a percentage. In the case of Entrepreneur D, our WACC is 12%. 17

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The weighted average cost of capital is used to discount cash flows for calculating NPV. As is shown here, our required rate of return, or WACC, is stated as 12%. Our investor wants to be in business for eight years. We look for the 12% interest and take the PV factor for each of the eight years and use them to calculate the present values. At which time we add up all of our present values and subtract our investment costs and restoration to get our Net Present Value. PART 6 WACC and how it applies to NPV 12% interest rate 8 years 18

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PART 7 WACC and how it applies to IRR The WACC is a percentage, in our case 12%. This is what will be the required minimum return necessary to pay back lenders, owners and security holders. The internal rate of return (IRR) will also be displayed as a percentage. The IRR will tell us whether or not the investment will have the required 12% return. The decision rule for IRR states: If the IRR exceeds the rate of return (or WACC) – invest If the IRR is less than the rate of return (or WACC) – do NOT invest In our case, we would NOT invest because our IRR is 11.680%, which is less than our WACC of 12% 19

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RESOURCE PAGE Horngren, C., Harrison Jr., W., Oliver, M. (2008) Accounting. Upper Saddle River: Prentice Hall Wikipedia (2013, March 27). Weighted average cost of capital. Retrieved from http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital 20

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