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Time Value of Money

Time Value of Money. Increases in value over time/inflation Interest (principle * rate * time) Simple Compound Value in long-term capital budgeting decision Present value Future value. Capital Budgeting. Planning process used to determine a firm’s long term investments

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Time Value of Money

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  1. Time Value of Money • Increases in value over time/inflation • Interest (principle * rate * time) • Simple • Compound • 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 • 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 = $50,200 – project accepted

  9. South Pacific Corporation • Invest $700,000 • Uneven cash flows of • $200,000 – 1st year • $350,000 – 2nd year • $250,000 – 3rd year • 15% - minimum required rate of return

  10. Invest $29,287.34 • Cash flows of - $8,560/year • 5 years • 14% - minimum required rate of return

  11. Read Chapters 8 and 9, • Assign #13 – Capital budgeting problem – use format, ½ page – what do you think? • Assign #14 – Rowe Case – use format, ½ page – what do you think?

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