1. 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

2. 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

3. 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)

4. 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

5. 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%

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

7. 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

8. 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

9. 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

10. Period1%2%3%4%5%6%7%8%9%10%11%12%13%14%15% 10.9900.9800.9710.9620.9520.9430.9350.9260.9170.9090.9010.8930.8850.8770.870 20.9800.9610.9430.9250.9070.8900.8730.8570.8420.8260.8120.7970.7830.7690.756 30.9710.9420.9150.8890.8640.8400.8160.7940.7720.7510.7310.7120.6930.6750.658 40.9610.9240.8880.8550.8230.7920.7630.7350.7080.6830.6590.6360.6130.5920.572 50.9510.9060.8630.8220.7840.7470.7130.6810.6500.6210.5930.5670.5430.5190.497 60.9420.8880.8370.7900.7460.7050.6660.6300.5960.5640.5350.5070.4800.4560.432 70.9330.8710.8130.7600.7110.6650.6230.5830.5470.5130.4820.4520.4250.4000.376 80.9230.8530.7890.7310.6770.6270.5820.5400.5020.4670.4340.4040.3760.3510.327 90.9140.8370.7660.7030.6450.5920.5440.5000.4600.4240.3910.3610.3330.3080.284 100.9050.8200.7440.6760.6140.5580.5080.4630.4220.3860.3520.3220.2950.2700.247 110.8960.8040.7220.6500.5850.5270.4750.4290.3880.3500.3170.2870.2610.2370.215 120.8870.7880.7010.6250.5570.4970.4440.3970.3560.3190.2860.2570.2310.2080.187 130.8790.7730.6810.6010.5300.4690.4150.3680.3260.2900.2580.2290.2040.1820.163 140.8700.7580.6610.5770.5050.4420.3880.3400.2990.2630.2320.2050.1810.1600.141 150.8610.7430.6420.5550.4810.4170.3620.3150.2750.2390.2090.1830.1600.1400.123 160.8530.7280.6230.5340.4580.3940.3390.2920.2520.2180.1880.1630.1410.1230.107 170.8440.7140.6050.5130.4360.3710.3170.2700.2310.1980.1700.1460.1250.1080.093 180.8360.7000.5870.4940.4160.3500.2960.2500.2120.1800.1530.1300.1110.0950.081 190.8280.6860.5700.4750.3960.3310.2770.2320.1940.1640.1380.1160.0980.0830.070 200.8200.6730.5540.4560.3770.3120.2580.2150.1780.1490.1240.1040.0870.0730.061 250.7800.6100.4780.3750.2950.2330.1840.1460.1160.0920.0740.0590.0470.0380.030 300.7420.5520.4120.3080.2310.1740.1310.0990.0750.0570.0440.0330.0260.0200.015 350.7060.5000.3550.2530.1810.1300.0940.0680.0490.0360.0260.0190.0140.0100.008 400.6720.4530.3070.2080.1420.0970.0670.0460.0320.0220.0150.0110.0080.0050.004 500.6080.3720.2280.1410.0870.0540.0340.0210.0130.0090.0050.0030.0020.0010.001

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