Capital Budgeting Decisions

1. 14 Chapter Capital Budgeting Decisions UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

2. Time Value of Money UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

3. Future Value Today . . . Future . . . Add interest at interest rate “i” for “n” periods.

4. Simple Interest Interest Rate P x R x T Principal Time

5. Simple Interest • Suppose you invest $100 at an interest rate of 10%. At the end of one year you would have $110. $100 + ($100 x .10 x 1) = $110 P x R x T

6. Future Value of $1

7. FV of Single Cash Flow

8. Present Value

9. The Concept of Present Value Today . . . Future . . . Deduct interest at interest rate “i” for “n” periods. Reverse Compounding

10. The Formulas Future Value Present Value

11. Present Value Formula

12. Using the PV Formula • What is the present value of $1,000 received five years from now if your required rate of return is 12%.

13. Using the PV Formula

14. Present Value Factors

16. Compounding Illustrated Future Value $567.43 for 5 years @ 12% compounded annually

17. 1 2 3 4 5 567.43 x 1.12 ------------ $635.52 $635.52 x 1.12 ------------ $711.78 $711.78 x 1.12 ------------ $797.19 $797.19 x 1.12 ------------ $893.65 $893.65 x 1.12 ------------ $1000.88 Compounding Illustrated Add interest for “5” periods at 12%.

18. Reverse Compounding Illustrated Present Value $1,000 for 5 years @ 12% compounded annually

19. 1 2 3 4 5 $635.53 ------------ 1.12 $567.44 $711.79 ------------ 1.12 $635.53 $797.20 ------------ 1.12 $711.79 $892.86 ------------ 1.12 $797.20 $1,000.00 ------------ 1.12 $892.86 Reverse Compounding Illustrated Deduct interest for “5” periods at 12%.

20. Practice Exercise 1 Using Present Value Tables

21. 1 2 3 4 5 Years Practice Exercise 1 • What is the present value of $100 received at the end of five years if the required return is 10%? ? $100 Exhibit 14C-3 Present Value of $1

22. $100 x .621 = $62.10

23. Practice Exercise 2 Using Present Value Tables

24. 1 2 3 4 5 Years Practice Exercise 2 • What is the present value of $100 per year for five years if the required return is 10%? ? ? $100 $100 $100 $100 $100 $100 Exhibit 14C-4 Present Value of an Annuity of $1 in Arrears

25. $100 x 3.791 = $379.10

26. Practice Exercise 3 Using Present Value Tables

27. Practice Exercise 3 • Examine the table “Present Value of $1” • Explain why the numbers decrease as you move from left to right in a given row.

28. The numbers decrease from left to right in a given row because cash received in the future is worth less the higher your required rate of return. Remember the formula:

29. Practice Exercise 4 • Examine the table “Present Value of $1” • Explain why the numbers decrease as you move from left to right in a given row. • Explain why the numbers decrease as you move from top to bottom in a given column.

30. The numbers decrease from top to bottom in a given column because cash received further in the future is less valuable today. Remember the formula:

31. Practice Exercise 5 Calculate Present Value

32. Practice Exercise 5 • Suppose you face the prospect of receiving $200 per year for the next 5 years plus an extra $500 payment at the end of 5 years. • Determine how much this prospect is worth today if the required rate of return is 10%. Annuity Lump Sum

33. PV of Annuity of $1 - Table 14C-4 N=5, i=10 PV of $1 - Table 14C-3 N=5, i=10

34. Practice Exercise 6 Calculate Present Value

35. Practice Exercise 6 • Juanita Martinez is ready to retire and has a choice of three pension plans. • Plan A provides for an immediate cash payment of $100,000 • Plan B provides for the payment of $10,000 per year for 10 years and $100,000 at the end of year 10. • Plan C will pay $20,000 per year for 8 years. 8% Required Rate of Return

36. Plan A: • Plan B: • Plan C: