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NPV and IRR - Using the BAII Plus Professional Calculator NPV and IRR - Using the BAII Plus Professional Calculator Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 15

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Net Present Value (NPV) and Internal Rate of Return (IRR) Both are capital budgeting methods Both use time value of money concepts Both allow the comparison of future cash flows at the date the investment is expected to occur NPV Calculates the dollar value that the cash flows are worth today IRR Calculates the rate of return that the cash flows are expected to generate 2

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Net Present Value Method (NPV) Step 1 Identify all cash flows of a potential investment Draw a time line and label inflows and outflows Step 2 Discount all cash flows to their present values Use required rate of return (hurdle rate) Step 3 Determine the NPV Combine (add/subtract) the PV of cash inflows with the PV of the outflows Step 4 Accept or reject the proposal 3

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How to Interpret & Assess NPV If the NPV is zero The investment will earn a return equal to the required rate of return. Accept the investment because it earns exactly the minimum return stipulated by management. If the NPV is positive The investment will earn a return greater than the required rate of return. Accept the investment because it earns more than the minimum return stipulated by management. If the NPV is negative The investment will earn a return less than the required rate of return. Reject the investment because it earns less than the minimum return stipulated by management. 4

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Internal Rate of Return (IRR) An alternative to the NPV method The rate of return that equates the present value of future cash flows to the investment outlay The rate that generates a zero NPV Useful when Comparing two or more investments Comparing to the company’s required rate of return 5

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Interpret IRR If the IRR is equal to the RRR The investment should be accepted because it earns the minimum rate stipulated by management. If the IRR is greater than the RRR The investment should be accepted because it earns more than the minimum rate stipulated by management. If the IRR is less than the RRR The investment should be rejected because it earns less than the minimum stipulated by management. 6 Assume the IRR is 10%......... The investment will generate an annual return of cash flows of 10%. Assume the IRR is 10%......... The investment will generate an annual return of cash flows of 10%.

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BAII Plus Professional Required for FIN 3403, your next business class Contains a number of different financial functions Much like a worksheet in Excel ® in that it contains cells that hold data

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Cash Inflows and Outflows in the BAII Amounts inputted stay in the CF worksheet until erased Even if you turn your calculator off Must specify cash flow directions Cash inflows Enter as positive numbers Cash outflows Entered as negative numbers Cash flow (CF) worksheet A stored worksheet/function in the BAII calculator Used to determine NPV and IRR of a series of future cash flows

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Frequency Function on BAII Useful when the annual cash flow amount is expected to be the same numeric amount for multiple years Frequency field appears as F01, F02, etc. Where F = frequency 01, 02 = the period correlating to the respective cash flows, e.g., C01, C02, etc. If the cash flow amount you entered is expected to be the same for two years, change the frequency from 1.00000 to 2.00000 If the cash flow amount you entered is expected to be the same for three years, change the frequency from 1.00000 to 3.00000 9

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Data Input on the BAII Plus Professional To open the CF worksheet: Press [CF] Close and exit from the CF worksheet: Press [CF] [2 nd ] [CPT]

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Data Input on the BAII Plus Professional How to set to 5 decimals Press [2 nd ] [Format] The screen will display: DEC 2.00 Enter [5] as the number of decimals places to be displayed Press [Enter] [2 nd ] [CPT] How to set to 5 decimals Press [2 nd ] [Format] The screen will display: DEC 2.00 Enter [5] as the number of decimals places to be displayed Press [Enter] [2 nd ] [CPT] Recommended for ACG 2071 Default setting = 2 decimal places Can display up to 8 places

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12 WD, Inc. is deciding whether to make an investment of $2,000 for a machine that is expected to provide net cash inflows of $500 for year 1, $800 for year 2, and $1,400 for year 3. WD’s required rate of return is 8.3%. Evaluate. (2000) 500 800 1400 CFO C01 C02 C03

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13 Ace, Inc. is deciding whether to make an investment of $2,000 for a machine that is expected to provide net cash inflows of $800 per year for 3 years. WD’s required rate of return is 5.1%. Evaluate. (2000) 800 800 800 CFO C01 C02 C03

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14 The End

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IRR on the BAII Calculator WD, Inc. is deciding whether to make an investment of $2,000 for a machine that is expected to provide net cash inflows of $500 for year 1, $800 for year 2, and $1,400 for year 3. WD’s required rate of return is 8.3%. Evaluate. Step 1: Enter the CF worksheet: [2 nd ] [CF] Step 2: Clear the cash flow worksheet: [2 nd ] [CE/C] The screen will display CF0 = 0.0000 Step 3: Input the cash flow for year 0: [2000] [+/-] [Enter] The +/- key toggles from positive to negative. Step 4: Press [ ]. Input the CF for year 1: [500] [Enter] continued

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IRR on the BAII cont. Step 5: Press [ ]. Accept the ‘1’ default for FO1 by pressing [ ] again. Step 6: Input the CF for year 2: [800] [Enter] Step 7: Press [ ] twice and input the CF for year 3: [1400] [Enter] Step 8: Press [IRR]. Step 9: Press [ ] [CPT]. Answer = 13.98% WD, Inc. is deciding whether to make an investment of $2,000 for a machine that is expected to provide net cash inflows of $500 for year 1, $800 for year 2, and $1,400 for year 3. WD’s required rate of return is 8.3%. Evaluate.

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NPV on the BAII Step 1: Enter the CF worksheet: [2 nd ] [CF] Step 2: Clear the cash flow worksheet: [2 nd ] [CE/C] The screen will display CF0 = 0.0000 Step 3: Input the CF for year 0: [2000] [+/-] [Enter] The +/- key toggles from positive to negative. Step 4: Press . Input the CF for year 1: [500] [Enter] continued WD, Inc. is deciding whether to make an investment of $2,000 for a machine that is expected to provide net cash inflows of $500 for year 1, $800 for year 2, and $1,400 for year 3. WD’s required rate of return is 8.3%. Evaluate.

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NPV on the BAII cont. Step 5: Press [ ]. Accept the ‘1’ default for FO1 by pressing [ ] again. Step 6: Input the CF for year 2: [800] [Enter] Step 7: Press [ ] twice and input the CF for year 3: [1400] [Enter] Step 8: Press [NPV]. At the I= prompt, input 8.3 [Enter] for the interest rate. Step 9: Press [ ] [CPT]. Answer = $245.91 WD, Inc. is deciding whether to make an investment of $2,000 for a machine that is expected to provide net cash inflows of $500 for year 1, $800 for year 2, and $1,400 for year 3. WD’s required rate of return is 8.3%. Evaluate.

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Calculating NPV and IRR If you need to calculate both NPV and IRR Input the cash flows only once To calculate NPV immediately after you solve for IRR, perform only steps 8 and 9 of the NPV instructions: Step 8: Press [NPV]. At the I= prompt, input 8.3 [Enter] for the interest rate. Step 9: Press [ ] [CPT] To calculate IRR after you solve for NPV, perform only steps 8 and 9 of the IRR instructions: Step 8: Press [IRR] Step 9: Press [ ] [CPT]

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20 The End

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