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PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
12-2
Learning Objective 1
Working Initial
capital investment
Incremental
operating
costs
12-11
Release of
Reduction
working
of costs
capital
Incremental
revenues
12-12
Present value of $1
factor for 3 years at 10%.
12-21
Present value of $1
factor for 5 years at 10%.
12-22
Quick Check
Denny Associates has been offered a four-year contract
to supply the computing requirements for a local bank.
Quick Check
What is the net present value of the
contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
12-25
Quick Check
What is the net present value of the
contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
Cash 14% Present
d. $132,916 Years Flows Factor Value
Investment in equipment Now $ (250,000) 1.000 $ (250,000)
Working capital needed Now (20,000) 1.000 (20,000)
Annual net cash inflows 1-4 120,000 2.914 349,680
Upgrading of equipment 2 (90,000) 0.769 (69,210)
Salvage value of equip. 4 10,000 0.592 5,920
Working capital released 4 20,000 0.592 11,840
Net present value $ 28,230
12-26
Cost $300,000
Productive life 10 years
Salvage value 7,000
Replace brushes at
the end of 6 years 50,000
Salvage of old equip. 40,000
Quick Check
Consider the following alternative projects. Each project would last
for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects.
Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
12-36
Quick Check
Consider the following alternative projects. Each project would last
for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects.
Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
Cash 14% Present
c. NPV of Project A > NPV
Differences in cash flows Years
of Project
Flows
B by $2,000
Factor Value
d. NPVinofequipment
Investment Project B >Now
NPV of
$ Project
(20,000) A by1.000
$2,000 $ (20,000)
Annual net cash inflows 1-5 4,000 3.433 13,732
Salvage value of equip. 5 2,000 0.519 1,038
Difference in net present value $ (5,230)
12-37
New Truck
Purchase price $ 21,000
Annual operating costs 6,000
Salvage value in 5 years 3,000
12-40
Quick Check
Bay Architects is considering a drafting machine
that would cost $100,000, last four years, and
provide annual cash savings of $10,000 and
considerable intangible benefits each year. How
large (in cash terms) would the intangible
benefits have to be per year to justify investing
in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
12-43
Quick Check
Investment in machine
Annual net cash inflows
Now
1-4
$ (100,000)
10,000
1.000
2.914
$ (100,000)
29,140
Annual intangible benefits 1-4 ? 2.914 ?
Bay Architects
Net present value
is considering a drafting machine
$ (70,860)
that would cost $100,000, last four years, and
provide annual cash savings
$70,860/2.914 of $10,000 and
= $24,317
considerable intangible benefits each year. How
Cash 14% Present
large (in cash terms) would
Years
the
Flows
intangible
Factor Value
benefits
Investment have to be
in machine per year
Now to justify1.000
$ (100,000) investing
$ (100,000)
innet
Annual thecash
machine
inflows if the
1-4discount rate is2.914
10,000 14%? 29,140
Annual intangible benefits 1-4 24,317 2.914 70,860
a. $15,000
Net present value $ (0)
b. $90,000
c. $24,317
d. $60,000
12-44
Learning Objective 2
Investment
A B
Net present value of project $1,000 $1,000
Investment required 80,000 5,000
Project profitability index 1% 20%
Other Approaches to
Capital Budgeting Decisions
Other methods of making capital
budgeting decisions include . . .
The Payback Method.
Simple Rate of Return.
12-50
Learning Objective 3
Determine the
payback period
for an investment.
12-51
$140,000
Payback period = $35,000
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
12-55
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. X
• Project Project Y
has a payback period of 2 years.
• Project
c. Y has a payback
Cannot period of slightly more than 2 years.
be determined
• Which project do you think is better?
12-56
Criticisms
of the payback
period. Ignores cash
flows after
the payback
period.
12-57
1 2 3 4 5
12-59
1 2 3 4 5
12-60
Learning Objective 4
Compute the
simple rate of return
for an investment.
12-61
*Should be reduced by any salvage from the sale of the old equipment
12-62
PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
12-66
Learning Objective 5
Understand present
value concepts and the
use of present value tables.
12-67
Fn = P(1 + r)n
12-69
Fn = P(1 + r)n
F1 = $100(1 + .08)1
F1 = $108.00
12-70
Compound Interest
What if the $108 was left in the bank for a
second year? How much would the
original $100 be worth at the end of the
second year?
Fn = P(1 + r)n
12-71
Compound Interest
F2 = $100(1 + .08)2
F2 = $116.64
The interest that is paid in the second year
on the interest earned in the first year is
known as compound interest.
12-72
Present Future
Value Value
Present Value
If a bond will pay $100 in two years,
what is the present value of the $100 if
an investor can earn a return of 12% on
investments?
Fn
P=
(1 + r)n
12-74
Present Value
$100
P= 2
(1 + .12)
P = $79.72
This process is called discounting. We have
discounted the $100 to its present value of
$79.72. The interest rate used to find the
present value is called the discount rate.
12-75
Present Value
Let’s verify that if we put $79.72 in the bank today
at 12% interest that it would grow to $100 at the
end of two years.
Year 1 Year 2
Beginning balance $ 79.72 $ 89.29
Interest @ 12% $ 9.57 $ 10.71
Ending balance $ 89.29 $ 100.00
If $79.72 is put in the bank today and earns
12%, it will be worth $100 in two years.
12-76
Quick Check
How much would you have to put in the
bank today to have $100 at the end of five
years if the interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
12-78
Quick Check
How much would you have to put in the
bank today to have $100 at the end of five
years if the interest rate is 10%?
a. $62.10
b. $56.70
$100 0.621 = $62.10
c. $90.90
d. $51.90
12-79
1 2 3 4 5 6
12-80
Quick Check
If the interest rate is 14%, how much
would you have to put in the bank today so
as to be able to withdraw $100 at the end
of each of the next five years?
a. $ 34.33
b. $500.00
c. $343.30
d. $360.50
12-83
Quick Check
If the interest rate is 14%, how much
would you have to put in the bank today so
as to be able to withdraw $100 at the end
of each of the next five years?
a. $ 34.33
b. $500.00
c. $343.30 $100 3.433 = $343.30
d. $360.50
12-84
Quick Check
If the interest rate is 14%, what is the present
value of $100 to be received at the end of the
3rd, 4th, and 5th years?
a. $866.90
b. $178.60
c. $ 86.90
d. $300.00
12-85
Quick Check
If the interest rate is 14%, what is the present
value of $100 to be received at the end of the
3rd, 4th, and 5th years?
a. $866.90
b. $178.60
c. $ 86.90
d. $300.00
$100(3.433-1.647) = $100(1.786) = $178.60
or
$100(0.675+0.592+0.519) = $100(1.786) = $178.60
12-86
End of Chapter 12