Time Value of Money Increases in value over time/inflation Increases in value over time/inflation Interest (principle * rate * time) Interest (principle * rate * time) – Simple – Compound Value in long-term capital budgeting decision Value in long-term capital budgeting decision – Present value – Future value

Capital Budgeting  Planning process used to determine a firm’s long term investments  Limited resources – efficient use – produce goods and services  Prudent investment decisions – great care, deliberate analysis  Cost vs. benefits  Cost – current outlay, benefits – future value  Minimum required rate of return – discount future cash flows – present value  Interest rate to borrow?  Present ROA

Capital Budgeting  Methods - not consider time value of money:  Payback method - length of time to recover the cost of an investment, cash inflows = initial investment  Accounting rate of return – uses cash inflows and depreciation  Simple rate of return – net operating income (estimated revenue – estimated costs)

Capital Budgeting  Payback method –  Easy to do, simple to understand  Shortest route – get back initial capital  Does not measure the total value of the project  Initial investment/annual cash inflows  Using estimates of yearly profits  I.e. - if a project costs $100,000 and was expected to return $20,000 annually, the payback period would be $100,000/$20,000, or five years

Capital Budgeting  Accounting rate of return  (Annual cash inflows – depreciation)/initial investment  Depreciation – noncash expense – lower taxes  I.e. - if a project costs $100,000 and was expected to last 10 years and return $20,000 annually, the ARR would be (20,000-10,000)/100,000 = 10%

Capital Budgeting  Simple rate of return  Annual incremental net operating income/initial investment

Capital Budgeting  If appears to be profitable - more complex capital budgeting analysis is done  NPV - net present value - using expected returns and cost of capital, add value to firm after making the required cost of capital  Measures excess or shortfall of cash flows  Year 1 - Interest: $100 * 10% = $10 + $100 = $110  NPV: $110 / 1.1 = $100  Year 2 – Interest: $110 + ($110 * 10 %) = $11 + $110 = $121  NPV: $121/(1.1 * 1.1) = $100  IRR - internal rate of return - equates the estimated profits to the cost to see what rate of return actually is  NPV = $0

Oceanic Company Oceanic Company – Invest in machinery – increase revenue $1 million/year for next 10 years, cost = $5.6 million – Present value of $1 million/year for 10 years = $5,650,200 – Benefit – cost = $5,650,200 - $5, 600,000 = $150,200 – project accepted

South Pacific Corporation South Pacific Corporation – Invest $700,000 – Uneven cash flows of $200,000 – 1 st year $200,000 – 1 st year $350,000 – 2 nd year $350,000 – 2 nd year $250,000 – 3 rd year $250,000 – 3 rd year

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 Read Chapters 8 and 9,  Assignment – Rowe Case – use format