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Attribution Non-Commercial (BY-NC)

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n the slopesof Deer ValleySki Resortin ParkValley, Utahsite of the 2OO2Winter Olymp ic s s la lo m c o mp e t it io n -ma n a g e ria l accounting seemsa world away.But the counterwhere you rent your skis,the chairlift that whisksy o u u p t h e mo u n t a in , n d t h e re s t a u ra n t a you dinnerare all part of the resort's that serves recentexpansion. How did Deer V alley's developers e c id e t o s p e n d $ t 3 millio nt o e x p a n d d SnowParkLodge? Directorof Finance Jim Ma d s e ne x p la in s h a t wh e n t h e re s o rt t r ea ches target numberof sk ie rsp e r d a y a n d a t a rg e t le v e lo f p ro f it , a th e ownersexpand.B ut eache x p a n s io n s t me e t t wo re q u ire me n t s . mu Fir st,the projectmust be pro f it a b le . e c o n d , e r V a lle ymu s t e x p e c t De S to g et its money back on the in v e s t me n t a re la t iv e ly h o rt t ime . T o in s fig u re out which projects me e t t h o s e re q u ire me n t s ,De e r V a lle y ' s

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managers com p a ret h e a mo u n t o f t h e in v e s t me n tn e e d e dt o e x p a n d the resortwith the additionalrevenues expectedfrom expansion. The resort manage rsma k e t h is c o mp a ris o nu s in g t wo c a p it a l b u d g e t i n g techniques: 1. Net present valu+to predict whether the investmentwill be profitable 2. Payback period-to predict how long it will take to "get the money back" ffi

LearningObjectives

Describe the importance capitalinvestments of and the capitalbudgeting process Usethe paybackand accounting rate of return methodsto makecapital investment decisions Usethe time valueof moneyto computethe presentand future valuesof singlelumpsumsand annuities

ffi

$n this chapter, we'll seehow companies suchas Deervalley usenet presentvalue, paybackperiod, and other capital investment analysis techniques decidewhich to long-termcapitalinvestments make. to

CapitalBudgeting

Describe the importance capital of investments the and capitalbudgeting process The process of making capital investment decisions is often referred to as capital budgeting. Companies make capital investments when they acquire capital assets_ assetsused for a long period of time. Capital investments include buying new equipment, building new plants, automating production, and developing major commercial Web sites. In addition to affecting operations for many years, capital investments usually require large sums of money. Deer Valley's decision to spend $L3 million to expand Snow Park Lodge will tie up resourcesfor years to come-as will Chrysler's recent decision to spend $419 million revamping its Belvidere, Illinois, manufacturing plant. Capital investment decisions affect all types of businesses they try to become as more efficient by automating production and implementing new technologies. Grocers and retailers such as'Wal-Mart have invested in expensive self-scancheckout machines, while airlines such as Delta and Continental have invested in selfcheck-in kiosks. These new technologies cost money. How do managers decide

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whether these expansions in plant and equipment will be good investments?They use capital budgeting analysis. Some companies, such as Georgia Pacific, employ staff dedicated solely to capital budgeting analysis.They spend thousands of hours a year determining which capital investments to pursue.

In this chapter, we discussfour popular methods of analyzing potential capital investments: 1. Payback period 2. Accounting rate of return (ARR) 3. Net present value (NPV) 4. Internal rate of return (IRR) The first two methods, payback period and accounting rate of return, are fairly quick and easy to calculate and work well for capital investments that have a relatively short life span, such as computer equipment and software that may have a useful life of only three to five years. Management often uses the payback period and accounting rate of return to screen potential investments from those that are less desirable.The payback period provides management with valuable information on how fast the cash invested will be recouped. The accounting rate of return shows the effect of the investment on the company's accrual-based income. However, these two methods are inadequate if the capital investments have a longer life span. \7hy? Becausethese methods do not consider the time value of money. The last two methods, net present value and internal rate of return, factor in the time value of money, so they are more appropriate for longerterm capital investments such as Deer Valley's expansion of its lodge, ski runs, and chairlifts. Management often uses a combination of methods to make final capital investment decisions. Capital budgeting is not an exact science.Although the calculations these methods require may appear precise, remember that they are based on predictions about an uncertain future. These predictions must consider many unknown factors, such as changing consumer preferences,competition, and government regulations. The further into the future the decision extends, the more likely actual results will differ from predictions. Long-term decisions are riskier than shortterm decisions.

Focuson CashFlows

Generally acceptedaccounting principles (GAAP) are based on accrual accounting, but capital budgeting focuses on cash flows. The desirability of a capital is, inflows in asset depends on its ability to generate net cash inflows-that excess of outflows-over the asset's useful life. Recall that operating income based on accrual accounting contains noncash expenses such as depreciation expenseand bad-debt expense.The capital investment'snet cash inflows, therefore, will differ from its operating income. Of the four capital budgeting methods covered in this chapter, only the accounting rate of return method uses accrual-basedaccounting income. The other three methods use the investment's projected net cash inflows. What do the projected net cash inflows include? Cash inflows include future cash revenue generated from the investment, any future savings in ongoing cash

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operating costs resulting from the investment, and any future residual value of the asset.To determine the investment'snet cash inflows, the inflows arc netted against the investment's future cash owtflows, such as the investment's ongoing cash operating costs and refurbishment, repairs, and maintenance costs. The initial investment itself is also a significant cash outflow. However, in our calculations, we refer to the amount of the inuestment separately from all other cash flows related to the inuestment. The projected net cash inflows are "given" in our examples and in the assignmentmaterial. In reality, much of capital investment analysis revolves around projecting these figures as accurately as possible using input from employees throughout the organization (production, marketing, and so forth, depending on the type of capital investment).

CapitalBudgetingProcess

The first step in the capital budgeting process is to identify porential investments-for example, new technology and equipment that may make the company more efficient, competitive, and profitable. Employees, consultants, and outside sales vendors often offer capital investment proposals to management. After identifying potential capital investments, managers project the investments' net cash inflows and then analyze the investments using one or more of the four methods listed previously. Sometimesthe analysis involves a two-stage process:In the first stage,managers screenthe investmentsusing one or both of the methods that do not incorporate the time value of money: payback period or accounting rate of return. These simple methods quickly weed out undesirable investments. Potential investmentsthat "pass the initial test" go on to a second stage of analysis. In the second stage, managers further analyze the potential i n v e s tme n ts u s i ng the net present val ue or i nternal rate of return met hod. Because these methods consider the time value of money, they provide more accurate information about the potential investment's profitability. Since each method evaluatesthe potential investment from a different angle, some companies use all four methods to get the most "complete picture" they can about the investment. Somecompanies can pursue all of the potential investmentsthat meet or exceed their decision criteria. However, becauseof limited resources,other companies must engagein capital rationing and choose among alternative capital investments.Based on the availability of funds, managers determine if and when to make specific capital investments.For example, management may decide to wait three years to buy a certain piece of equipment becausethey consider other investments to be more important. In the intervening three years, the company will reassess whether it should still invest in the equipment. Perhaps technology has changed and even berter equipment is available. Perhaps consumer tastes have changed, so the company no longer needsthe equipment. Becauseof changing factors, long-term capital budgets are rarely "set in stone." Most companies perform post-audits of their capital investments. After investing in the assets,they compare the actual net cash inflows generated from the investment to the projected net cash inflows. Post-audits help companies determine whether the investments are going as planned and deserve continued s u p p o rt o r w h e t her they shoul d abandon the proj ect and sel l the asset s. Managers also use feedback from post-audits to better estimate net cash inflow projections for future projects. If managers expect routine post-audits, they will more likely submit realistic net cash inflow estimates with their capital investment proposals.

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Step1:

Step5:

PaybackPeriod

Payback is the length of time it takes to recover,in net cash inflows, the cost of the capital outlay. The payback model measures how quickly managers expect to recover their investment dollars. The shorter the payback period, the more attractive the asset,all else being eqwal.Why? The quicker an investment pays itself back, the less inherent risk that the investment will become unprofitable. Computing the payback period depends on whether net cash inflows are equal each year or whether they differ over time. We consider each in turn. and Usethe payback rateof accounting returnmethodsto makecapital investment decisions

investing$240,000in Tierra Firma makescampinggear.The companyis considering (B2B) hardwareand softwareto developa business-to-business portal. Employees throughoutthe companywill usethe B2Bportal to access company-approved suppliers. Tierra Firma expects portal to save$60,000eachyearfor the six yearsof its useful the personnel life. The savings the will arisefrom a reductionin the numberof purchasing

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company employs and from lower prices on the goods and servicespurchased.Net cash inflows arise from an increase in revenues, a decreasein expenses,or both. In Tierra Firma's case,the net cash inflows result from lower expenses. 'Sfhen net cash inflows are equal each yea\ managers compute the payback oeriod as follows:

Payback period = Amount invested Expected annual net cash inflow

Tierra Firma computes the investment'spayback as follows: Payback periodfor B2B portal = = 4 years

H#

Exhibit 9-1 verifies that Tierra Firma expects to recoup the $240,000 investment in the B2B portal by the end of Year 4, when the accumulated net cash inflows to ta l $ 2 4 0 ,0 0 0 .

Payback-Equal AnnualNetCashlnflows

Net CashInflows Web Site Annual Accumulated 80,000 150,000

,: it I t i.it.

0 1 2 3 4

.1

Annual

(;

Tierra Firma is also considering investing$240,000to developa Web site. The companyexpects 'Websiteto generate the $80,000in net cashinflows each ye^r of its three-year The payback periodis computed follows: life. as

= periodfor web sitedevelopment Payback = 3 years

-*qt# Exhibit 9-1 verifies that Tierra Firma will recoup the $240,000 investment for STebsite development by the end of Year 3, when the accumulated net cash inflows total $240,000.

The payback equation works only when net cash inflows are the same each period. \fhen periodic cash flows are unequal, you must accumulate net cash inflows until the amount invested is recovered.Assume that Tierra Firma is considering an alternate investment, the 280 portal. The 280 portal differs from the B2B portal and \feb site in two respects:(1) it has uneqwal net cash inflows during its life, and (2) it has a $30,000 residual value at the end of its life. The 280 portal will generatenet

475

cashinflows of $100,000in Year1, $80,000in Year2, $50,000eachyearin Years3 through 5, $30,000in Year 6, and $30,000when it is sold at the end of its life. Exhibit 9-2 showsthe paybackschedule theseunequalannualnet cashinflows. for Payback-Unequal Annual Net Cash Inflows

Year

Accumulated

{}

1 L 3 4

,r :l i t;,i i t) i l

-)

6

330,000 360,000

iit.

ResidualValue

By theendof Year3, thecompany recovered of inihas $230,000 the $240,000 tially invested Because expected cash the net and areonly $10,000short of payback. inflow in Year4 is $50,000,by the end of Year4, the companywill haverecovered more than the initial investment. Therefore, paybackperiodis somewhere the between threeand four years. Assuming that the cashflow occursevenlythroughoutthe fourth year,the paybackperiodis calculated follows: as

(amount $10,000 P ay bac k = 3y e a rs + = 3r2 Years

lete recoverv in Year 4) net cash inflow in Year 4)

A major criticism of the payback method is that it focuses only on time, not on profitability. The payback period considers only those cash flows that occur dwring the payback period. This method ignores any cash flows that occur after that period, including any residual value. For example, Exhibit 9-1 shows that the B2B portal will continue to generate net cash inflows for two years after its payback period. These additional net cashinflows amount to $120,000 ($60,000 X 2 years),yet the payback method ignores this extra cash. A similar situation occurs with the 280 portal. As shown in Exhibit 9-2, the 280 portal will provide an additional $150,000 of net cashinflows, including residual value, after its payback period of 3.2 years.In contrast, the rffeb site's useful life, as shown in Exhibit 9-1, is the sameas its payback period (threeyears).Sinceno additional cash flows occur after the payback period, the'Sfeb site will merely cover its cost and provide no profit. Becausethis is the case,the company has little or no reason to invest in the \Website even though its payback period is the shortest of all three investments. Exhibit 9-3 compares the payback period of the three investments. As the exhibit illustrates, the payback method does not consider the asset'sprofitability. The method only tells mandgement how quickly they will recouer tbeir cash. Even though the \fleb site has the shortest payback period, both the B2B portal and the 280 portal are better investmentsbecausethey provide profit. The key point is that

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paybackperiod is bestonly wben all otber factors with the shortest the investment usuallyusethe paybackmethod as a screening are the same.Thercfore,managers that device "weed out" investments will take too long to recoup.They rarely use to paybackperiodas the solemethodfor deciding whetherto investin the asset. 'Sfhen are usingthe paybackperiodmethod,managers guidedby the following rule: decision

to of are in business earn profits. One measure profitability is the Companies rate of return (ARR) on an asset: accounting ' i d"iro"iqp.rati4g,iniEqefrbhiaii.t A..orntin$ - Avalage l riteiof retuin

generThe ARR focuses the operatingincome,not the net cashinflow, that an asset on annualrate of return over the asset's Recall life. the ates.The ARR measures average Therefore, noncash any expenses incomeis based acuwalaccownting. on that operating must be subtracted from the asset's cashinflows to net expense such as depreciation is that depreciation expense the only noncash arriveat its operatingincome.Assuming we relatingto the investment, can rewritethe ARR formula asfollows: expense

lSome managers prefer to use the average investment rather than the initial investment as the denominator. For simpiicity, we will use the initial investment.

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Exhibit 9-4 reviews how to calculateannual depreciation expenseusing the straightline method.

Annual Initial cost of asset- Residual value = depreciation (in Usefullife of asset years) expense

Recallthat the B2Bportal, which costs$240,000,hasequalannualnet cashinflows of $60,000, six-year a useful life, and no residual value. First,we must find the B2B portal'sannualdepreciation expense: , Annual

l*o.nr.

Clepreclatlon = -

$z4o,oooo

6 Years

$60,000$4o,ooo*$20,000=8 , 3 3 Y o ( r o u n d e d ) =;

$240,000 $240,000

Now, consider 280 portal.Recall the that the 280 portalwould alsocost$240,000 but it had unequalnet cashinflows during its life (aspicturedin Exhibit 9-2) and a $30,000 residualvalue at the end of its life. Sincethe yearlycashinflows vary in size,we needto first calculate Z'80'sauerage the annualnet cashinflows: Total net cashinflows during operating of asset life (doesnot includethe residualvalueat end of life)'z (Year1 + Year2, andso forth)from Exhibit9-2.................... $360,000 Divideby: Asset's operating (in years)......... life - 6 years Average annualnet cashinflow from asset... Noq let'scalculate asset's the expense: annualdepreciation . Annual $24o.ooo$io.ooo = $ 60,000

d e p r e cfa tf o n = - - - - - - f 6 Ye a r s a "p a n r a

bJJ'U U U

zThe residual value is not included in the net cash inflows during the asset'soperating life because we are trying to find the asset's average annual operating income. 'We assume that the asset will be sold for its expected residual value ($30,0001 atthe end of its life, resulting in no additional accounting gain or loss.

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$24o,ooo

Notice that the 280 portal's average annual operating ($25,000) income is higher than the B2B portal's averageoperating income ($20,000). Since the 280 asset has a residual value at the end of its life, less depreciation is expensed each year, leading to a higher averageannual operating income and a higher ARR. Companies that use the ARR model set a minimum required accounting rate of return. If Tierra Firma required an ARR of at least I0"/o, its managers would not approve an investment in the B2B portal but would approve an investment in the 280 portal. The decisionrule is:

In summary the payback period focuseson the time it takes for the company to recoup its cash investment but ignores all cash flows occurring after the payback period. Becauseit ignores any additional cash flows (including any residual value), the method does not consider the profitability of the project. The ARR, however, measures the profitability of the asset over its entire life using accrual accounting figures. It is the only method that usesaccrual accounting rather than net cash inflows in its computations. As we will discussin Chapter 12, company divisions are often evaluated based on accounting income. Therefore, the investment's ARR helps managers see how the investment will impact their division's profitability. The payback period and ARR methods are simple and quick to compute, so managers often use them to screenout undesirable investments and to gain a more complete picture of the investment's desirability. However, both methods ignore the time value of money.

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Decision Guidelines

Capml Buocenruc

Amazon.com started as a virtual retailer. It held no inventory. Instead, it bought books and CDs only as neededto fill customer orders. As the company grew, its managers decided to invest in their own warehouse facilities. Why? Owning warehouse facilities allows Amazon.com to savemoney by buying in bulk. Also, shipping all items in the customer's order in one package from one location savesshipping costs. Here are some of the guidelines Amazon.com's managers used as they made the major capital budgeting decision to invest in building warehouses.

Decision

\fhy is this decision important?

Ifhat method shows us how soon we will recoupour cash investment?

Guideline

Capitalbudgeting decisions typicallyrequirelarge investments affectoperations yearsto come. and for The paybackmethodshowshow quickly managers will recouptheir investment. The methodhighlightsinvestmentsthat are too risky due to long paybackperiods. However,it doesn'trevealany informationabout the profitability. investment's

The accounting rate of return is the only capital budgeting method that shows how the investment will affect accrual accounting income, which is important to financial statement users.All other methods of capital investment analysis focus on the investment's net cash inflows.

Does any method consider the impact of the investment on accrual accounting income?

How do we computethe paybackperiod if cashflows areeqwal? How do we computethe paybackperiod if cashflows are unequal?

How do we compute the ARR?

ffirmh$em $ SwffiBffirffiffibfl

Zetamax is considering buying a new bar-coding machine for its Austin, Texas, plant. The company screensits potential capital investments using the payback period and accounting rate of return methods. If a potential investment has a payback period of lessthan four years and a minimum 7"/o accotnting rate of return, it will be considered further. The data for the machine follow:

$+g,OOO $ 0 5 years

Es ti ma te d n n u al net cashi nfl orv (eachyear for fi ve years)............ $t3,0O O a Estimated useful life Requirements t. Compute the bar-coding machine's payback period.

2. Compute the bar-coding machine's ARR. 3. Should Zetamax turn down this investment proposal or consider it further?

ffim$mx*fimm-m

Requirement I

Paybarck periocl= Amount invested Exoected annual net cash infiow

$48,000 $13,000

Average annual net cash inflow - Annual depreciation expense Initial investment $ 1 3 , 0 0 0- $ 9 , 6 0 0 o

= "Depreciationexpense $48,000+ 5 years= $9,600

Requirement 3 The bar-coding machine proposal passesboth initial screening tests. The payback period is slightly less than four years, and the accounting rate of return is slightly higher than 7"/o. Zetamax should further analyzethe proposal using a method that incorporates the time value of money.

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4A1

A dollar received today is worth more than a dollar to be received in the future. Why? Becauseyou can invest today's dollar and earn extra income. The fact that invested money earns income over time is called the time value of money, and this explains why we would prefer to receive cash sooner rather than later. The time value of money means that the timing of capital investments' net cash inflows is important. Two methods of capital investment analysis incorporate the time value of money: the NPV and IRR. This section reviews time value of money concepts to make sure you have a firm foundation for discussingthese two methods. Usethe time valueof moneyto compute the present and future val ues si nglelum p of sumsand annuit ies

The time value of money depends on severalkey factors: 1. The principal amount (p) 2. The number of periods (z) 3. The interest rate (i) The principal (p) refers to the amount of the investment or borrowing. Because this chapter deals with capital investments, we'll primarily discussthe principal in terms of investments. However, the same concepts apply to borrowings (which you probably discussedin your financial accounting course when you studied bonds payable).'We state the principal as either a single lump sum or an annuity. For example, if you want to save money for a new car after college, you may decide to invest a single lump sum of $10,000 in a certificate of deposit (CD). However, you may not currently have $10,000 to invest. Instead, you may invest funds as an annuitg depositing $2,000 at the end of each year in a bank savingsaccount. An annuity is a stream of eqwal installments made at equal time interuals.3 The number of periods (z) is the length of time from the beginning of the investment until termination. All else being equal, the shorter the investment period, the lower the total amount of interest earned. If you withdraw your savings after four years rather than five years, you will earn less interest. If you begin to save for retirement at age22 rather than age 45, you will earn more interest before you retire (you let time do the work). In this chapter, the number of periods is stated in years.4 The interest rate (i) is the annual percentageearned on the investment. Simple interest means that interest is calculated only on the principal amount. Compound interest means that interest is calculated on the principal and on all interest earned to date. Compound interest assumesthat all interest earned will remain inuestedat the same interest r*te, not witbdrawn and spent. Exhibit 9-5 compares simple interes't(6yo) on a five-year, $10,000 CD with interest compounded yearly (rounded to the nearest dollar). As you can see,the amount of compound interest earned yearly grows as the base on which it is calculated (principal plus cumulative interest to date) grows. Over the life of this particular investment, the total amount of compound interest is about 1,3Yomore than the total amount of simple interest. Most investments yield compound interest, so we assumecompound interest rather than simple interest for the rest of this chapter.

3An ordinary annwity is an annuity in which the installments occur at the end of each period. An annuity due is an annuity in which the installments occur at the beginning of each period. Throughout this chapter, we use ordinary annuities since they are better suited to assumptions about capital budgeting cash flow. 4The number of periods can also be stated in days, months, or quarters. If so, the interest rate needs to be adjusted to reflect the number of time periods in the year.

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Compound Interest

$10, 000x x $10, 000 $10, 000x $10, 000x x $10, 000 6% = 67" = 6% = 6' h= 6% =

Year

I

2 3

A

.5

x $10,000 ($10,000600\x + x ($10,000600+ 636) + ($10,000600+ 636+ 674)x + x ($10,000600+ 636+ 674+ 71.5\ +

67"= 6% = 6% = 67"= 6% =

Total interest

Total interest

83

lil

Fortunately, time value calculations involving compound interest do not have to be as tedious as shown in Exhibit 9-5. Formulas and tables (or proper use of business calculators programmed with these formulas) simplify the calculations. In the next sections,we will discusshow to use thesetools to perform time value calculations.

Almmg Fmf;nts Vailnres: mnnd Future Vmf,ues Pre$@r'nt ffieprntf,mwum the Tfrrne

valueof an investthe Consider time line in Exhibit 9-6.The future valueor present at ment simplyrefersto the valueof an investment differentpoints in time.

rWecan calculate the future value or the present value of any investment by know(or assuming)information about the three factors listed earlier: (1) the principal ing amount, (2) the period of time, and (3) the interest rate. For example, in Exhibit 9-5, we calculatedthe interestthat would be earnedon (1) a $10,000 principal (2) invested for five years (3) at 60/0 interest. The future value of the investment is its worth at the end of the five-year time frame-the original principal plws the interest earned. In our example, the future value of the investment is: earned Futurevalue= Principal+ Interest = $10,000+ $3,383 = $13,383 If we invest $10,000 today,its present ualue rs simply the $10,000 principal amount. So, another way of stating the future value is:

Future value = Presentvalue + Interest earned

48,3

The only difference between present value and future value is the amount of interest that is earned in the rntervenrngtrme span.

Calculating each period's compound interest, as we did in Exhibit 9-5, and then adding it to the present value to figure the future value (or subtracting it from the future value to figure the present value) is tedious. Fortunately, mathematical formulas simplify future value and present value calculations. Mathematical formulas have been developedthat specify future values and present values for unlimited combinations of interest rates (l) and time periods (n). Sepante formulas exist for single lump-sum investmentsand annuities. The formulas have been calculated using various interest rates and time periods. The results are displayed in tables. The formulas and resulting tables are shown in this chapter's Appendix 94: 1. PresentValue of $1 (Table A, p. 517)--used for lwmp-swmanlounts 2. PresentValue of Annuity of $1 (Table B, p. 518)-zsed for annuities 3. Future Value of $1 (Table C, p. 51,9)-used for lump-swm amounts 4. Future Value of Annuity of $1 (Table D, p. 520)-used for annwitrcs Take a moment to look at these tables becausewe are going to use them throughout the rest of the chapter. Note that the columns are interest rates (i) and the rows are periods (z). The data in each table, known as future value factors (FV factors) and present value factors (PV factors), are for an investment (or loan) of $1. To find the future value of an amount other than $1, you simply multiply the FV factor found in the table by the principal amount. To find the present value of an amount other than $1, you multiply the PV f.actorfound in the table by the principal amount. Rather than using these tables, you may want to use a businesscalculator or scientific calculator that has been programmed with time value of money functions. Programmed calculators such as Texas Instruments' BAII-Plus, TI-83 (Plus), and TI-84 (PIus) make time value of money computations much easier becauseyou do not need to find the correct PV and FV factors in the tables. Rather, you simply enter the principal amount, interest rate, and number of time periods in the calculator and instruct the calculator to solve for the unknown value. The appendices this chapter show step-by-step to directions for performing basic time value of money computations and for performing NPV and IRR computations: Instructions for TI-83 and TI-84 (or TI-83 Plus and TI-84 Plus): Appendix 98, beginning onp. 521 Instructions for BAII Plus: Appendix 9C, beginning on p. 529 Instructions for operating other programmed calculators can usually be found on the manufacturer's Web site. In addition,'Web sites such as atomiclearning.com offer free online video tutorials for some calculators. The appendices also show step-by-step use of these calculators for every problem illustrated throughout the rest of the chapter. As you will see in these

9 Chapter

appendices,using a programmed calculator results in slightly different answers than those presented in the text when using the tables. The differences are due to the fact that the PV and FV factors found in the tables have been rounded to three digits. Finally, all end-of-chapter material has been solved using both the tables and programmed calculators so that you will have the exact solution for the method you chooseto use.

Suams ffi# Fwtmrm ffimf;smHmtfin'ng Vmfiues Sfrmrugfiw mrnd ffsfimg ffimetmrs &mmnxfrtfies ffiW

Let's go back to our $10,000 lump-sum investment. If we want to know the future value of the investment five years from now at an interest rate of 6"/",we determine the FV factor from the table labeled Future Value of $1 (Appendix 9A, Table C). \7e 'We look down the 6olocolumn and acrossthe use this table for lump-sum amounts. periods row and find that the future value factor is 1.338. \7e finish our calculations 5 as follows: Futurevalue= Principalamount x (pViltlt;. 'fori. 6o1n,l:,s) = $10,000 (1.338) x = $13,390 This figure agreeswith our earlier calculation of the investment's future value ($13,383) in Exhibit 9-5. (The differenceof $3 is due to two facts: (1) the tables round the FV and PV factors to three decimal places, and (2) we rounded our earlier vearly interest calculations in Exhibit 9-5 to the nearestdollar.) 5years

Let's also consider our alternative investment strategy' investing $2,000 at the end of each year for five years. The procedure for calculating the future value of an annuity is similar to calculating the future value of a lump-sum amount. T h i s ti me , w e use the Future V al ue of A nnui ty of $1 tabl e (A ppendix 9A, Table D). Assuming 6oh interesq we once again look down the 67o column. Be c a u s ew e w i l l be maki ng fi ve annual i nstal l ments, w e l ook across the r ow 'We finish the calculation as marked 5 periods. The Annuity FV factor is 5.637. follows: x Futurevalue= Amount of eachcasbinsrallment (AnnuityFV factor for i = 6o/",n = 5) = $2,000x (5.637) = $tL,274 This is considerablyless than the future value ($13'380) of the lump sum of $10,000 even though we invested$10,000 out of pocket either way.

445

Explainwhythefuturevalueof theannuity($11,274)is lessthanthefuturevalueof the lumpsum ($13,380). valueis correct calculatProve that the $11,274future by ing interest usingthe "longhand" methodshownearlier. As'il$wwr* Eventhough you invested out $'10,000 of pocket under both investments,the timing of the investment affects the amountof interest significantly earned. The $10,000 lumpsum invested interest the fullfive for immediately earns years. However, annuity the untilYear2 (because doesn'tbegin earninginterest the firstinstallment isn'tmade untilthe end of Year'1). addition, In the amount invested beginsat $2,000 and doesn'treacha full $'10,000 untiltheend of Year5. Therefore, baseon whichthe interest earnedis smaller the is thanthe lump-sum investment the entire for period. shownhere, $11,274 future five-year As the value of a $2,000 annuity fiveyearsis correct. for

The process for calculating present values-often called discounting cash flows-is similar to the process for calculating future values. The difference is the point in time at which you are assessing investment'sworth. Rather than determining its the value at a future date, you are determining its value at an earlier point in time

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(today). For our example, let's assumethat you've just won the lottery after purchasing one $5 lottery ticket. The state offers you three payout options for your aftet-tax prlze money:

alternative should you take? You might be tempted to wait ten years to "double" your winnings. You may be tempted to take the money now and spend it. However, let's assums that you plan to prudently invest all money received-no matter when you receive it-so that you have financial flexibility in the future (for example, for buying a house, retiring early, and taking vacations). How can you choose among the three payment alternatives when the total amounZ of each o p ti o n v a ri e s ($ 1 ,000,000 versus $1,500,000 versus$2,000,000) and the t im ing oi the cash flows varies (now versus some each year versus later)? Comparing these three options is like comparing apples to oranges-we just can't do itunlesswe finJ some common basis for comparison. Our common basis for comparison will be the prize money's worth at a ceftain point in time-namel5 today. in other words, if we convert each payment option to its present ualue, we can compare apples to apples. 'We already know the principal amount and timing of each payment option' so only assumption we'll have to make is the interest rate. The interest rate will the vary depending on the amount of risk you are willing to take with your investment. Riskierlnvestments (such as stock investments)command higher interest rates; safer investments (such as FDlC-insured bank deposits) yield lower interest rates. Let's assumethat after investigating possible investment alternatives, you choose an investment contract with an 8o/oannual return. 'We already know that the present value of Option #1 is $1,000'000. Let's convert the other two payment options to their present values so that we can compare them. We'll need to use the Present Value of Annuity of $1 table (Appendix 9A' Table B) to convert payment Option #2 (sinceit's an annuity) and the PresentValue of $1 table (Appendix 9A, Table A) to convert payment Option #3 (sinceit's a single lump sum). To obtain the PV factors, we look down the 87o column and across the 10 period row Then, we finish the calculations as follows:

'Which

Exhibit 9-7 shows that we have converted each payout option to a common basis-its worth today-so we can make a valid comparison of ihe options. Based on this comparison, we should choose option #2 becauseits worth, in today's dollars, is the highest of the three optrons.

0ption #1

0ption#2

$r50,000 $1 50,000 $1 50,000 $1 50,000 $1 50,000 $150,000 $150,000 $150,000 $150,000 $150.000

0ption#3

9 Chapter

S u p p o s e y o u d e ci de to i nvest your l ottery w i nni ngs very conservatively. You d e c i d e to i n v e s t i n a ri sk-free i nvestment that earns onl y 3% . W oul d you st ill choose payout Option #2? Explainyour decision.

When the lotterypayout is investedat 3% ratherthan 8%, the presentvalues its because presentvalueis the change.Option #3 is now the best alternative in to sensitive changes are extremely valuesand futurevalues Present highest. periodis relatively long. whenthe investment especially rateassumptions, interest

the Now that we have studied time value of money concepts' we will discuss two capital budgeting methods that incorporate the time value of money:net present value (NPV) and internal rate of return (IRR).

Neither the payback period nor the ARR incorporate the time value of money. Discownted cash flow models-the NPV and the IRR-overcome this weakness. These models incorporate compound intefest by assuming that companies will reinvest furure cash flows when they are received. Over 85% of large industrial firms in the United States use discounted cash flow methods to make capital investment decisions. Companies that provide services,like Deer ValleS also use these models.

489

The NPV and IRR methods rely on present value calculations to compare the amount of the investment (the investment'sinitial cost) with its expected net cash inflows. Recall that an investment'snet cash inflows includes all future cash flows related to the investment, such as fwture increased sales and cost savings netted against the investment'sfuture cash operating costs. Becausethe cash ou"t, flow for the investment occurs now but the net cash inflows from the investment occur in the future, companies can make valid "apple-to-apple" comparisons only when they convert the cash flows to the sami point ii ii*r-nu dy, the present value. Companies use the present value rather than the future lr"l,r. to make the comparison becausethe investment'sinitial cost is already stated at its p res ent v alue. 5 As shown in Exhibit 9-8, in a favorable investment, the present value of the investment's net cash inflows exceedsthe initial cost of the investment. In terms of our earlier lottery example, the lottery ticket turned out to be a "good investment" becausethe present value of its net cash inflows (the present ual.le of the lottery payout under any ofthe three payout options) exceeded cost ofthe investment(the the $5 lottery ticket). Let's begin our discussion taking a closerlook at the NPV method. by

Comparing Present the Valueof an Investment's CashInflows Net Againstthe Investment's InitialCost

il

Allegra is considering producing cD playersand digital video recorders(DVRs). The productsrequiredifferentspecialized machines, eachcosting$1 million. Each

5If the investment is to be purchased through leasepayments rather than a currenr cash outlag we would still use the current cash price of the investment as its initial cost. If no current cash price is avaiiable, we would discount the future leasepayments back to their present value to estimate the invistment's current cash orice.

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machine has a five-year life and zero residual value. The two products have different patterns of predicted net cash inflows:

more net cash inflows, but the DVR proiect The CD-player proiect generates To decide how attractive each investment is, we find its net brings in cash sooner. present value (NPV). The NPV isthe differencebetween the present value of the investment's net cash inflows and the investment's cost. We discount the net cash inflows to their present value-just as we did in the lottery example-using Allegra's minimum desired rate of return. This rate is called the discount rate it because is the interestrate used for the presentvalue calculations.It's also called the required rate of return or hurdle rate becausethe investment must meet or exceed this rate to be acceptable.The discount rate depends on the riskiness of investments.The higher the risk, the higher the discount rate. Allegra's discount rate for theseinvestmentsis 14%. the present value of the net cash inflows to the investment'sinitial -Wecompare cost to decide which projects meet or exceedmanagement'sminimum desiredrate of return. In other words, management is deciding whether the $1 million is worth the more (because company would have to give it up now to invest in the project) or whether the project's future net cash inflows are worth more. Managers can make a valid comparison between the two sums of money only by comparing them at the same point in time-namely, at their present value.

Allegra expects the CD-player project to generate $305,450 of net cash inflows each year for five years. Becausethese cash flows are equal in amount and occur every year, they are an annuity. Therefore, we use the PresentValue of Annuity of $1 table (Appendix gA,Table B) to find the appropriate Annuity PV factor fo ri :1 4 o /" ,n :5 . The present value of the net cash inflows from Allegra's CD-player project is: value= Amount of eachcashinflow X (AnnuityPV factor for i = L4To,n = 5l Present = $305,450 (3.433) x = $1,048,610 Next, we subtract the investment'sinitial cost ($1 million) from the present value of the net cashinflows ($1,048,610).The differenceof $48,610 is the net present value (NPV), as shown in Exhibit 9-9.

491

Presentvalue of annuity of equal annual net cash inflows for 5 years at 1,4o/o Investment Net present value of the CD-plaver oroiect

PV factor is found in Appendix 9A, Table

A positiue NPV means that the project earns more than the required rate of return. A negatiue NPV means that the project fails to earn the required rate of return. This leads to the following decision rule:

In Allegra's case, the CD-player project is an attractive investment. The $48,610 positive NPV means that the CD-player project earnsmore than Allegra's 1,4o/o target rate of return. In other words, management would prefer to give up $1 million today to receive the CD-player project's future ner cash inflows. \7hy? Becausethose future net cash inflows are worth more than $1 million in today's dollars (they are worth $1,048,610). Another way managers can use present value analysis is to start the capital budgeting process by computing the total present value of the net cash inflows from the project to determine the maximum the company can invest in the project and still earn the target rate of return. For Allegra, the present value of the net cash i n fl ows is $1, 048 ,6 1 0 . T h i s m e a n s th a t A l l e gra can i nvest a maxi mum of $1,048,610 and still earn the 1,47otargetrate of return. Because Allegra'smanagers believe they can undertake the project for $1 million, the project is an attractive rnvestment.

In contrast to the CD-player project, the net cash inflows of the DVR project are unequal-$500,000 in Year 1, $350,000 in Year 2, and so forth. Becausethese amounts vary by year, Allegra's managers cannot use the annuity table to compute the present value of the DVR project. They must compute the present value of each individual year's net cash inflows separately (as separate lump sums receiued in different years)usingthe PresentValue of $1 table (Appendix 94, Table A). Exhibit 9-10 shows

Chapter 9

Present Value

760

1,078,910

1

in that the $500,000net cashinflow received Year 1 is discounted using a PV net factorof i : 14o/o, : l, while the $:SO,OOO cashinflow received fl inYear 2 is discountedusing a PV factor of i : 1,4o/o, : 2, and so forth. After sepan rately discounting eachof the five year'snet cashinflows, we find that the total present net valueof the DVR project's cashinflows is $1,078,910. Finally,we subtractthe investment's cost ($1 million) to arrive at the DVR project'sNPV: $78,910. Because NPV is positive,Allegra expectsthe DVR project to earn more the than the 14o/o target rateof return, makingthis an attractiveinvestment.

Exhibits 9-9 and 9-10 show that both the CD-player and DVR projects have positive NPVs. Therefore, both are attractive investments.Because resourcesare limited, companies are not always able to invest in all capital assetsthat meet their investment criteria. For example, Allegra may not have the funds to invest in both the DVR and CD-player projects at this time. In this case, Allegra should choose the DVR project becauseit yields a higher NPV. The DVR project should earn an addirequired rate of return, while the CD-player project tional $78,910 beyond the 1.4o/" returns an additional $48,610. This example illustrates an important point. The CD-player project promises more total net cash inflows. But the timing of the DVR cash flows-loaded near the beginning of the project-gives the DVR investment a higher NPV. The DVR project is more attractive because of the time value of money. Its dollars, which are received sooner, are worth more now than the more distant dollars of the CD-player project. If Allegra had to choose between the CD and DVR project, it would choose the DVR project becausethat project yields a higher NPV ($78,910). However, comparing the NPV of the two projects is valid only because both projects require the same initial cost-$1 million. In contrast, Exhibit 9-11 summarizes three capital investment options that Raycor, a sporting goods manufacturer, faces. Each capital project requires a different initial investment. All three projects are attractive becauseeach yields a positive NPV. Assuming that Raycor can invest in only one project at this time, which one should it choose? Project B yields the highest NPV, but it also requires a larger initial investment than the alternatives.

493

To choose among the projects, Raycor computes the profitability index (also known as the present value index). The profitability index is computed as follows: Profitabilityindex= Present valueof net cashinflows+ Investment The profitability index computes the number of dollars returned for every dollar invested, with all calculations performed in present ualwedollars. It allows us to compare alternative investments in present value terms (like the NPV method) but also considersdifferencesin the investments'initial cost. Let's compute the profitability index for all three alrernatives.

P r o j e cA: t Project B: P r o j e cC : t

$ 1 5 0 ,0 0 0 $238,000 $ 1 8 2 ,0 0 0

1.20 r. 1 . 9

1.21

The profitabilityindex showsthat ProlectC is the bestof the threealternatives because returns$f .Zt 1inpresent it valuedollars)for every$1.00invested. Prolects A and B returnslightlyless. Let'salsocompute profitabilityindexfor Allegra's the cD-playerandDVR projects:

DVR:

= $ 1 ,0 7 8 ,9 1 0 - $1,000,000

= - $1,000,000

1..049 1.079

The profitability index confirmsour prior conclusion that the DVR projectis more profitablethan the CD-player project.The DVR projectreturns$1.ozg (in presentvalue dollars)for every$1.00 invested. This return is beyond the 14%o return alreadyusedto discountthe cashflows. \fle did not needthe profitability index to determine that the DVR project was preferable because both projects requiredthe sameinvesrment million). ($1

Many assetsyield cash inflows at the end of their useful lives because they have residual value. Companies discount an investment'sresidual value to its present value when determining the total present value of the project's net cash inflows. The residual value is discounted as a single lump sum-not an annuity-because it will be received only once, when the assetis sold. SupposeAllegra expectsthe CD projec equipment to be worth $100,000 at the end of its five-year life. This represents an additional future cash inflow from the CD*player project. To determine the CD-player project's NPV, we discount th e re s idual v alue ($ 1 0 0 ,0 0 0 ) u s i n g th e Pre s e nt V al ue of $1 tabl e (i : 14% " ,

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to value($51,900) AppendixgA,TableA).'We then addits present n: 5) (see as value of the CD project'sother net cashinflows ($1,048,610) the present shownin Exhibit 9-12: NPV of a Project with ResidualValue

PV Factor ( i =1 4 %, n = 5 )

Presentvalue of annuity Presentvalue of residual value (single lump sum) Total present value of net cash inflows Investment Net present value (NPV)

3.433 0.519

x x

= $30s,450 = i 00,000

residualvalue,the CD-playerproject is now more Because the expected of only the CD or DVR project, project.If Allegracouldpursue than the DVR attractive projectbecause NPV ($100,510) higherthan the is its the it would now choose CD ($1 ($78,910) both projects investment million). require same the and DVR project

Sensitivity Analysis

Capital budgeting decisionsaffect cash flows far into the future. Allegra's managers might want to know whether their decision would be affected by any of their major For example: assumptions. . . . Changing the discount rate from 14oh to 12o/oor to 16o/" Changing the net cash flows by 1'0% Changing an expected residual value

After entering the basic information for NPV analysis into spreadsheetsoftware or programmed calculators, managers perform sensitivity analyseswith just a few keystrokes. The software quickly recalculatesand displays the results.

The NPV method only tells management whether the investment exceedsthe hurdle rate. Sinceboth the CD-player and DVR proiects yield positive NPVs, we know they rute of return. But what exact rate of return would these provide more than a 1.4%o investmentsprovide? The IRR method answers that question. The internal rate of return (IRR) is the rate of return, based on discounted cash flows, that a company can expect to earn by investing in the project. It is the interest rate that makes tbe NPV of the inuestmentequal to zero: NPV=0 Let's look at this concept in another light by inserting the definition of NPV cost net valueof the investment's cashinflows - Investment's = 0 Present the O r i f w e re a rrange equati on: net valueof the investment's cashinflows Investment's = Present cost

495

In other words, the IRR is the interest rate that makes the cost of the investment equal to the present value of the investment'snet cash inflows. The higher the IRR, the more desirablethe project. Like the profitability index, the IRR can be used in the capital rationing process. IRR computations are very easy to perform on programmed calculators. (See Appendices 9B and 9C.) However, IRR computations are much more cumbersome to perform using the tables.

N7hen the investment is an annuity, we can develop a formula that will tell us the Annuity PV factor associated with the investment's IRR. -S7estart with the equation given above and then substitute in as follows: Investment's cost = Presentvalue of the investment's net cash inflows Investment's cost = Amount of each equal net cash inflow X Annuity PV factor (i = ?, n = given) FinallS we rearrange the equation to obtain the following Investment's cost Amount of each equal net cash inflow formula:

Let's usethis formula to find the Annuity PV factor associated with Allegra's CD-playerproject.Recallthat the projectwould cost $1 million and resultin five equalyearlycashinflowsof $305,450:

ffi

'3.274 =Annuity PV factor(i = ?,n = 5l

Next, we find the interest rate that corresponds to this Annuity PV factor. Turn to the PresentValue of Annuity of $1 table (Appendix 9A, Table B). Scan the row corresponding to the project's expected life-five years, in our example. Choose the column(s) with the number closestto the Annuity PV factor you calculated using the formula. The 3.274 annuity factor is in the 16o/ocolumn. Therefore, the IRR of the CD-player project is 1,6Y.. Allegra expects the project to earn an internal rate of return of 1,67oover i ts lif e. E x hibit 9 -1 3 c o n fi rm s th i s re s u l r: U si ng a 1.67o di scount rate, rhe p ro jec t ' s NP V is z e ro . In o th e r w o rd s , 1 ,6 o hi s the di scount rate that makes th e inv es t m ent c o s t e q u a l to th e p re s e n t v a lue of the i nvestment' s net cash inflows.

IRR-CD-Player Proiect

Total Present

i = L6" h.n= 5

Presentvalue of annuity of equal annual net cash inflows for 5 years at L6To Investment

tSlight rounding error *The zero difference proves that the IRR is 16%

Value

$305,450

496

Chapter9

To decide whether the project is acceptable, compare the IRR with the minimum desired rate of return. The decision rule is:

Because CD project's hurdle rateis 1.4oh. the IRR (16%) is Recallthat Allegra's Allegrawould investin the project. higherthan the hurdle rate(1,4o/"), in In the CD-playerproject,the exactAnnuity PV factor (3.274)appears the Present Value of an Annuity of $1 table (Appendix9A, TableB). Many times,the in exactfactor will not appear the table. For example,let's find the IRR of Tierra Firma'sB2B Portal. Recallthat the B2B portal had a six-yearlife with annualnet find its Annuity PV faccost$240,000.'We cashinflows of $60,000.The investment tor usingthe formula givenpreviously:

Valueof Annuity of $1 tablein the row marked6 periods Now; look in the Present (Appendix9A, TableB). You will not see4.00 under any column.The closest two factorsare3.889(at 1,4"/.) and4.11,1. bt1,2%\.

If we useda calculatorprogrammedwith the IRR function, we would find the TierraFirmahad a 14o/" hurdlerate,it would zof investin the exactIRR is 12.98%".If B2Bportal because portal'sIRR is less the than 14%.

Because DVR projecthasunequalcashinflows,Allegracannotusethe Present the Value IRR. Rather, Allegramust usea trial-and-error of Annuity of $1 tableto find the asset's procedure determine discountrate that makesthe project'sNPV equalto zero. the to discountrate is $78,910. Recallfrom Exhibit 9-L0 that the DVR's NPV using a 1,4o/o positiue,thelRRmustbe higherthanl4Y".AllegraperformsthetrialSincetheNPVis process ratesuntil it findsthe ratethat bringsthenetpreusinghigherdiscount and-error the sentvalueof the DVR proiectto zero.Exhibit 9-14 showsthat at 1,6Yo. DVR hasan

497

NPV of $40,390;therefore, IRR must be higherthan 167". At 18o/", NPV is the the $3,980,which is very closeto zero.Thus,the IRR must be slightlyhigherthan 18%".If we usea calculatorprogrammed with the IRR function rather than the trial-and-error procedure, would find that the IRR is 18.23%. we

The DVR's internal rateof return is higherthan Allegra's1.4%" hurdle rate, so the DVR projectis attractive.

ComparingCapitalBudgetingMethods

'We havediscussed four capitalbudgeting methods commonlyusedby companies to make capital investmentdecisions. Two of thesemethodsdo not incorporatethe time valueof money:paybackperiod and ARR. Exhibit 9-15 summarizes simithe laritiesand differences between these two methods.

Compareand contrast

+L^ f^,,lr r9 rvur ^^^:+^l LoPtLol

budgetingmethods

residualvalu!

t Highlights risks of investments with tonger cash recovery periods o Ignores the time value of money lgnores time value money

4iiEr uYcI rrb El.[r{s rlrE

l.

r x*{ru;i *r*i a:** *r-r,id hr d^u;*r , money ' lgnores the time value of ,, , , , . ,,,, ,. : :il.

498

Chapter 9

The discounted cash flow methods are superior becausethey consider both the time value of money and profitability. These methods compare an investment's initial cost (cash outflow) with its future net cash inflows-all converted to the samepoint in time-the present value. Profitability is built into the discounted cash flow methods becausethey consider all cashinflows and outflows over the project's life. Exhibit 9-16 considersthe similarities and differencesbetween the two discountedcashflow methods.

o Incorporates the time value of money and the aiset's net cash flows over its entire life . Indicates whether the assetwill earn the company's minimum required rate of retufn . Shows the excessor deficiency of the present value of net cash in{lows asset's ovef rts lnrttal lnvestment cost . The profitability ir-rdexshould be computed w fo r ca p ir a l r a tio n ing deci si ons hen the a sse ts' r e q u ird i fferent i ni ti al j nvestmenrs e

on Managersoften usemore than one methodto gain differentperspectives risks pursuecapitalprojects DeerValley'sownerscould decideto and returns.For example, havea paybackof four yearsor less. with positiveNPV providedthoseprojects

W

projects that require the is two company considering research A pharmaceutical payback A and Project hasan NPVof $232,000 a 3-year sameinitialinvestment. periodof 4.5years. Which and period. Project hasan NPVof $237,000 a payback B project wouldyou choose? A would chooseProject even though it has a slightly ,il,r,:'tt;vfl,trvtrir; Many managers periodis signifiyet lower, the payback lowerNPV Why?The NPVis only $5,000 with of operatingcashflowsincreases The uncertainty receiving cantlyshorter. in often forgo smalldifferences expectedcash each passingyear.Managers the inflows decrease riskof investments. to

4gg

Decision Guidelines

Capml Buocerrruc

Here are more of the guidelines Amazon.com's managers used as they made the major capital budgeting decision to invest in building warehouses.

Decision

\X/hich capitalbudgeting methodsare best?

\7hy do the NPV and IRR models calculate the present value of an investment'snet cash flows?

Guideline

No one method is best. Each method provides a different perspective on the investment decision. Becausean investment'scash inflows occur in the future, yet the cash outlay for the investment occurs now, all of the cash flows must be converted to a common point in time. These methods use the present value as the common poinr in time.

How do we compute the net present value (NPV) if the investment has equal annual cash inflows?

Investment warehouse in facilitiesmay be worthwhile if the NpV is positiveor the IRR exceeds requiredrate the of return.

Compute the present value of the investment'snet cash inflows using the PresentValue of an Annuity of $1 table and then subtract the investment'scost. Compute the present value of each year's net cash

How do we compute the net present value (NPV) if the investment has unequal annual cash inflows?

inflows usingthe Present Valueof $1 (lump sum)table, sum the present valueof the inflows, and then subtract the investment's cost. Find the inrerestratethatyieldsthe following Annuity PV facror:

Annuity PV factor

Investment's cost Amount of each equal net cash inflow

How do we compute the internal rate of return (IRR) if the investment has unequal annual cash inflows?

Use trial and error, a businesscalculator, or spreadsheet software to find the IRR.

? FnCIblernm Su$mffi?ffiry

Recall from Summary Problem 1 that Zetamax is considering buying a new barcoding machine. The investment proposal passedthe initial screeningtests (payback period and accounting rate of return), so the company now wants to analyzethe proposal using the discounted cash flow methods. Recall that the bar-coding machine costs $48,000, has a five-year life, and has no residual value. The estimatednet cash inflows are $13,000 per year over its life. The company's hurdle rate is 1,60/o. Requirements L. Compute the bar-coding machine's NPV. 2. Find the bar-coding machine's IRR (exact percentagenot required). 3. Should Zetamax buy the bar-coding machine?'$7hy or why not?

Smf,utfimen

Requirement I

rl:t

'i:'it

i:'i

j-

- A n n u i t y P V f a c t o r ( i =? , n =g i v e n )

frffi

$48,000 =

3.692= AnnuityPV factor(i = ?,n = 5l the Because cash inflows occur for five years,we look for the PV factor 3.692 in row marked n: 5 on the PresentValue of Annuity of $1 table (Appendix 9A, the TableB). The PV factor is 3.605 at1.2'h and3.791at 10%. Therefore,the bar-coding machine has an IRR that falls between 10"/. and 12"h. (Optional: Using a programrned calculator,we fir-rdan 11.038"/. internal rate of return.)

ii; 'r .i :, I'

Decision: Do not buy the bar-coding machine. It has a negative NPV, and its IRR falls below the company's required rate of return. Both methods shorv that this investment does not meet management'sminimum requirements for investments of this nature.

500

Chapter 9

RgVigW

of Money

mAccounting Vocabulary

Accounting Rate of Return. (p.4Z6l A measureof profitability computedby dividing the averageannualoperatingincomefrom an asset by the initialinvestment the asset. in Annuity. (p. 481) A streamof equal installments made at equal time intervals. Gapital Budgeting. g. aTOl The processof making capital investment decisions.Companiesmake capital investments when they acquirecapitalassefsassets used for a long period of time. Gapital Rationing. (p. 4721 Choosingamong alternative capitalinvestments due to limitedfunds. Compound Interest. (p. 481) lnterestcomputed on the principaland all interestearnedto date. Discount Rate. (p. 490) Management's minimumdesiredrate of return on an investment. Also calledthe hurdlerate and requiredrate of return. Internal Rate of Return (lRR). (p. a9a) The rate of return(basedon discounted cash flows) that a company can expect to earn by investing a capitalasset.The interest in rate that makesthe NPVof the investment equalto zero. Net Present Value (NPV). (p. 490) The difference between the present value of the investment's cash inflowsand the net investment's cost. Payback. (p. a73) The lengthof time it takes to recover, net in cash inflows,the cost of a capitaloutlay. Post-Audits. b. a72l Comparinga capitalinvestment's actual net cash inflows to its projected net cash inflows. Profitability Index. (p. 493) An indexthat computesthe numberof dollars returnedfor everydollar invested, with all calculations pertormed in present value dollars. Computedas presentvalueof net cash inflows divided by investment. Also calledpresent valueindex. Simple Interest. (p. 481) lnterestcomputedonly on the principal amount. Time Value of Money. (p. a81) The fact that moneycan be investedto earn incomeover time.

w Q,uickCheck

1. Which of the following methodsusesaccrualaccounting rather than net cash flows as a basisfor calculations? a. payback b. ARR c. NPV d. IRR 2. tD7hich the following methodsdoesnot consider investment's of the profitabiliry? a. payback b. ARR c. NPV d. IRR

CapitalInvestment Decisions and the Time Valueof Monev 501

a. b. c. d. Companies should always choose the investment with the shortest payback period. Companies should always choose the investment with the highest NPV. Companies should always choose the investment with the highest ARR. None of the above.

4. Your rich aunt has promised to give you $3,000 a year at the end of each of the

next four years to help you pay for college. With a discount rate of 10o/o,the present value of the gift can be stated as: a. PV : $3,000 (PV factor, i : 4"/", n : 10)

b. PV: $3.000x 10% x 5 PV i: c. PV : $3,000X (Annuity factor, 'LjYo,n: 4) FV d. PV : $3,000x (Annuity factor, L0Y",n: 4) i: 'Which the valueof an investment? 5. of the following affects present rate a. the interest b. the numberof time periods(lengthof the investment) (annuityversus c. the type of investment singlelump sum) d. all of the above 6. When making capital rationing decisions, sizeof the initial investment the requiredmay differ betweenalternativeinvestments. The profitability index can be usedin conjunctionwith which of the following methods, help manto agers choose between alternatives? a. IRR b. ARR Period c. Payback d. NPV 7. The IRR is a. the sameasthe ARR b. the firm's hurdlerate is c. the interestrateat which the NPV of the investment zero d. none of the above Amazon.com considering is investing warehouse-management in 8. Suppose softhas warethat costs$500,000, $50,000residual value,and shouldleadto cost savings $120,000per year for its five-yearlife. In calculating of the ARR, which of the following figuresshouldbe usedasthe equation's denominator? a. $225,000 b. $500,000 c. $250,000 d. $275,000 9. Usingthe informationfrom Question8, which of the following figuresshould numerator(average be usedin the equation's annualoperating income)? a. $120,000 b. $20,000 c. $30,000 d. $10.000

so2

Chapter9

10. Which of the following is the most reliablemethodfor making capital budgeting decisions? a. NPV method b. ARR method c. paybackmethod method d. post-audit

p' 0 1 2 ' 6 q ' 8 )' L P' 9 p ' S )' V p' t o' 7 q' I

For lnternet Exercises,Excel in Practice,and additional online activities, go to this book's Web site at www.prenhall.com/bamber.

AssessYour Progress

mLearning Objectives

ffit and the capitalbudgetingprocess Describe the importanceof capitalinvestments rate of return methodsto makecapitalinvestment Usethe paybackand accounting decisions value moneyto computethe presentand future valuesof single

m

ffi ffit

wShort Exercises

s9-1

Order the capital budgeting process (Learning Obiectiue 7) Place the following activities in sequence illustrate the capital budgeting process: to a. Budget capital investments b. Project investments' cash flows c. Perform post-audits d. Make investments investmentsalready made e. Use feedback to reassess f. Identify potential capital investments g. Screen/analyze investments using one or more of the methods discussed

Chapter 9

s9-2

compute payback period-equal cash inflows (Leaming objectiue2) Referto the AllegraData Set.Calculate CD-player the project's paybackperiod.If the CD projecthad a residual valueof $100,000,would the paybackperiodchange? Explainand recalculate necessary. if Doesthis investment pass Allegra's paybackperiodscreening rule? compute payback period-unequal cash infrows (Leaming objectiue2) Referto the Allegra Data Set.Calculatethe D\rR project'spaybackperiod. If the DVR projecthad a residual valueof $100,000, would thepayback periodchange? Explainand recalculate necessary. this investment if Does passAllegra's paybackperiodscreening rule? Compute ARR-equal cash inflows (LearningObiectiue 2) Referto the AllegraData Set.Calculate CD-playerproject'sARR. If the CD prothe ject had a residualvalue of $100,000,would the ARR change? Explain and recalculate if necessary. Doesthis investment passAllegra's ARR screening rule? Compute ARR-unequal cash inflows (LearningObiectiue 2) Referto the Allegra Data Set.Calculate DVR project'sARR. If the DVR proJecr the had a residualvalueof $100,000,would the ARR change? Explain and recalculate if necessary. Doesthis investment passAllegra's ARR screening rule? Compute annual cash savings (LearningObiectiue 2) Suppose Allegra is decidingwhether to invest in a DVD-HD project. The payback period for the $5 million investment four years,and the project'sexpectid life is is seven years. What equalannualnet cashinflows are expected from this project? Find the present values of future cash flows (Leaming objectiue3) Your grandfather would like to sharesomeof his fortune with you. He offersto give you moneyunderone of the following scenarios (you get to choose): t. $8,000a yearat the end of eachof the next eightyears

2, $50,000 (lump sum) now 3. $100,000 (lump sum) eight yearsfrom now Calculate the present value of each scenario using a 6%ointerest rate. Which scenario yields the highest present value? Would your preference change if you used a I2yo interest rate?

s9-3

S9-4

S9-5

59-6

s9-7

s9-8

Show how timing affects future values (Leaming Obiectiue 3) Assume that you make the following invesrments: a. b. c. You invest a lump sum of $5,000 for four years at 1,2o/o intercst. \il/hat is the investment'svalue at the end of four years? In a different account earning 1,2o/o interest,you invest $1,250 at the end of each year for four years. what is the investment'svalue at the end of four years? What general rule of thumb explains the difference in the investments' furure values?

s9-9

Compare payout options at their future values (Leaming Objectiue 3) Refer to the lottery payour options on page 486. Rather than compare the payout options at their present values (as is done in the chapter), compare the payout options at their future value ten years from now. a. b. c. using an 8olointerest rate, what is the future value of each payout option? Rank your preferenceof payout options. Does computing the future value rather than the present value of the options change your preferenceof payout options? Explain. CapitalInvestment Decisions and the Time Valueof Monev

S9-10

Relationship between the PV tables (Learning Obiectiue 3) Use the Present Value of $1 table (Appendix 9A, Table A) to determine the present value of $1 received one year from now Assume a 14"/" interest rate. Use the same table to find the present value of $1 received two years from now. Continue this processfor a total of five years. a. b. c. What is the total present value of the cash flows received over the five-year period? 'S7hy or why not? Could you characterize this stream of cash flows as an annuity? Use the PresentValue of Annuity of $1 table (Appendix 9,{, Table B) to determine the present value of the same stream of cash flows. Compare your results to your answer in Part a. Explain your findings.

d. S9-11

Compute NPV-equal net cash inflows (Learning Objectiue 4) Skyline Music is considering investing $750,000 in private lesson studios that will have no residual value. The studios are expectedto result in annual net cash inflows of $100,000 per year for the next ten years. Assuming that Skyline Music uses an 8% hurdle rate, what is net present value (NPV) of the studio investment? Is this a favorable investment? Compute |RR-equal net cash inflows (Learning Objectiue 4) Refer to Skyline Music in S9-11. \X/hat is the approximate internal rate of return (IRR) of the studio investment?

S9-12

4) Objectiue 59-13 ComputeNPV-unequal net cash inflows (Leaming is in kiosks for investing self-check-out supermarketconsidering ThelocalGiantEagle value. kiosks cost$45,000 have residual and no The will its customers. self-check-out

over threeyearsas Management expects equipmentto resultin net cashsavings the grow accustomed using the new technology: to customers $t4,000 the first year; year;$24,000 third year. Assumingal}Yo discountrate,what the $19,000the second 'Why Is investment? or why not? is the NPV of the kiosk investment? this a favorable 59-14 4) Gompute |RR-unequal net cash inflows (LearningObiectiue internal rateof return (IRR) Referto Giant Eaglein 59-13.\X/hatis the approximate of the kiosk investment?

w Exercises

E9-15 7, Write a memo to employees about capital budgeting (LearningObiectiues 5) and want your new employees be well informed to You have just starteda business (1) \7rite a memoto your employees explainingwhy capital about capitalbudgeting. budgetingis important, (2) briefly describingthe four methods of analyzingcapital and weaknesses, (3) explaining and investments along with someof their strengths why your companywill post-auditall capitalinvestments. 2) Compute payback period-equal cash inflows (Leaming Objectiue plant. The purchase price is acquiringa manufacturing Quiksilveris considering net the The $1,236,1,00. ownersbelieve plant will generate cashinflows of $309,025 in annually.It will haveto be replaced eight years.To be profitable,the investment payback must occur before the investment'sreplacementdate. Use the payback this whetherQuiksilvershouldpurchase plant. methodto determine

E9-16

506

Chapter9

E9-17

2) Gompute payback period-unequal cash inflows (LearningObjectiue of SikesHardware is adding a new product line that will require an investment life will havea ten-year and genManagers estimate that this investment $L,454,000. eratenet cashinflows of $310,000the first year,$280,000the secondyear,and has for $240,000 eachyearthereafter eight years.The investment no residualvalue. Computethe paybackperiod. 2) ARR with unequal cash inflows (LearningObiectiue Referto the Sikes Hardwareinformation inB9-17. Computethe ARR for the investment. 2) Compute and compare ARR (LearningObjectiue Managersare considering two Engineered Productsis shoppingfor new equipment. investments. Equipmentmanufactured Atlas costs$1,000,000and will last five by will generate annualoperating yearsand haveno residual value.The Atlas equipment and will manufactured Verascosts$1,200,000 by incomeof $160,000. Equipment annualoperatingincomeof $240,500,and its remainusefulfor six years.It promises expected residual valueis $100,000. \7hich equipment offersthe higherARR? Compare retirement savings plans (Leaming Obiectiue3) Assume that you want to retireearly at age52,You plan to saveusingone of the fol(1) when you are 22 lowing two strategies: save$3,000 a yearin an IRA beginning and endingwhen you are 52 (30 years) (2) wait until you arc 40 to start savingand or that you will earnthe historic Assume then save$7,500per yearfor the next L2 years. stockmarket average 10% per year. of Requirements 1. How much out-of-pocket cashwill you investunderthe two options? at 2. How much savings will you haveaccumulated age52 underthe two options? 3. Explainthe results. 4, If you let the savings continueto grow for ten more years(with no further outbe what will the investment worth undereachscenario, of-pocketinvestments), when you are age62?

E9-18

E9-19

E9-20

E9-21

Show the effect of interest rate on future values (Learning Obiectiue3) Your bestfriend just received gift of $5,000from his favoriteaunt.He wantsto save a He the moneyto useas startermoneyafter college. can (1) investit risk-freeat3oh, (2) take on moderate (3) take on high risk at 1,6%.Helpyour friend risk at 8o/o,or projectthe investment's strategy worth at the end of four yearsundereachinvestment and explainthe results him. to Fund future cash flows (Learning Obiectiue3) Janetwants to take the next five yearsoff work to travel around the world. Sheestimore, she'llwork odd jobs). matesher annualcashneeds $30,000(if sheneeds at her shedepletes funds. at she Janetbelieves can investher savings 8% until Requirements '1.. How much moneydoesJanetneednow to fund her travels? 2. After speaking with a numberof banks,Janetlearnsshe'llbe ableto investher fundsonly at 6"/". How much doessheneednow to fund her travels?

E9-22

5|,7

E9-23

3) Ghoosing a lottery payout option (LearningObiectiue Congratulations! You'vewon a statelotto. The statelottery offersyou the following (after-tax) payoutoptions:

Assuming that you can earn 8"/" on your funds,which option would you prefer?

1. Suppose investa sum of $2,500in an accountbearinginterestat the rate of you '!7hat per be 1,4o/" year. will the investment worth six yearsfrom now? 2. How much would you needto investnow to be ableto withdraw $5,000at the Assume 1,2o/o interest rate. end of everyyearfor the next20 years? a yearsfrom now. If you can 3. Assume that you want to have$150,000savedseven interest rate, how much do you currentlyneedto investyour fundsat a 6o/o invest? 4. Your aunt Bettyplansto giveyou $1,000at the end of everyyearfor the next interestrate,how much ten years.If you investeachof her yearlygifts at a 1,2o/o period? will they be worth at the end of the ten-year you 5. Suppose want to buy a smallcabin in the mountainsfour yearsfrom now. You estimate that the propertywill cost $52,500at that time. How much moneydo you needto investeachyearin an accountbearinginterestat the rate price? of 6 percentper yearto accumulate $52,500purchase the

whetherSalonProductsshouldinvestin the folUse the NPV method to determine lowing projects: o ProiectA: Costs$272,000and offerseight annualnet cashinflows of $60,000. SalonProducts requires annualreturn of 14'/. on projectslike A. an c Project Costs B: and offersnineannualnet cashinflowsof $70,000. $380,000 SalonProducts demands annualreturn of 1,2%on investments this nature. an of \il/hat is the maximum acceptable price to pay for What is the NPV of eachproject? eachproject? E9-26 4) Galculate IRR-equal cash inflows (LearningObjectiue in Referto SalonProducts E9-25.Computethe IRR of eachprojectand usethis information to identifvthe betterinvestment.

508

Chapter 9

E9-27

Calculate NPV-unequal cash llows (Learning Objectiue 4) Bevil Industries is deciding whether to automate one phase of its production process. The manufacturing equipment has a six-year life and will cost $900,000. Projectednet cash inflows are as follows:

$260,000

$25,o,ooo

$225,000 ,$210,000 $200,000 $175,000

Requirements 14o/o 1. Computethis project's NPV usingBevilIndustries's hurdlerate. Should BevilIndustries \fhy or why not? investin the equipment? 2. BevilIndustries at could refurbishthe equipment the end of six yearsfor providing The refurbished equipment couldbe usedonemoreyear, $100,000. equipment $75,000of net cashinflows in Year7. In addition,the refurbished BevilIndustries would havea $50,000residual valueat the endof Year7. Should \X/hyor why not? (Hint:In investin the equipment refurbish aftersix years? it and 1, the additionto your answer Requirement discount additional to cashoutflow and inflowsbackto the present value.)

Ritter Razors considering equipment that Projected is an investment will cost$950,000. net cashinflows over the equipment's life three-year are as follows:Year 1: $500,000; Year2: $400,000; Ritter wantsto know the equipment's IRR. and Year3: $300,000. Requirements Usetrial and error to find the IRR within a 2o/orange.(HintzUseRitter'shurdle rate process.) of 10'/" to beginthe trial-and-error Optional:Usea business calculatorto computethe exactIRR.

proposals. this time, Sheffield Manufacturing considering At is threecapitalinvestment Sheffield Manufacturinghas funds availableto pursueonly one of the three invest'Which pursueat this time?Why? ments. investment Manufacturing shouldSheffield iquipment A

I

EquipmentB

Equipment C

509

E9-30

Compare the capital budgeting methods (Learning Objectiue 5) Fill in each statement with the appropriate capital budgeting method: payback period, ARR, NPV or IRR. a. b. c. d. e. incorporate the time value of money. and focuseson time, not profitability. usesaccrual accounting income. finds the discount rate that brings the investment's NPV to zero. In capital rationing decisions,the profitability index must be computed to compare investmentsrequiring different initial investmentswhen the method is used. ignores salvagevalue. usesdiscounted cash flows to determine the asset'sunique rate of return.

f. g.

h. i. -

highlightsrisky investments. profitability but ignores time valueof money. measures the

E9-31 Compute payback and ARR with residual value (Learning Objectiue 2)

Refer to the Deer Valley Expansion Data Set. 7. Compute the averageannual net cash inflow from the expansion. 2. Compute the averageannual operating income from the expanslon. 3. Compute the payback period. 4. Compute the ARR.

51O

Chapter 9

E9-32

Continuation of E9-31: Gompute payback and ARR with no residual value (Learning Objectiue2) Refer to the Deer Valley ExpansionData Set.Assumethat the expansionhas zero residwal ualwe.

Requirements l. Will the payback period change?Explain and recalculate if necessary. 2. Will the project's ARR change?Explain and recalculate if necessary. 3. Assume that Deer Valley screensits potential capital investmentsusing the following decisioncriteria:

Referto the DeerValleyExpansion Data Set. L. What is the project's NPV? Is the investment attractive? Why or why not? 2. Assume has ualwe.Whatis the project's NPV? Is that the expansion no residwal the investment attractive? still Why or why not?

Data Set. Asswme theex,pansion no residwal that has Referto the DeerValleyExpansion Nfhy or why not? ualwe,What the project's is IRR?Is the investment attractive?

Use your resultsfromE9-32,89-33, andE9-34 to write a memo to Deer Valley's Director of FinanceJim Madsenrecommending whetherDeer Valley should undertake the expansion, no ualwe.Coverthe strengths and weaknesses asswming residwal of eachcapitalbudgeting methodcitedin your memo.Usethe following format:

Date:

Subject:

51 I

P9-36A Apply capital budgeting to a current event (Learning Objectiue 7) Look through the businesssection of the newspaper.Find a company that has recently made a capital investment. Summarize the company's decision and then answer the following questions: lWhy is this a capital investment decision? \7hat effect will the 'What methods might the company have used to make decision have on the company? its decision?\fhat information would the company have used in making its decision? P9-37A Solve various time value of money scenarios (Leaming Objectiues 3,4) L. Jeff just hit the jackpot in Las Vegas and won $25,000! If he invests it now at a 1,2o/o interest rate, how much will it be worth in 20 years? 2. Evan would like to have $2,000,000 savedby the time he retires in 40 years. How much does he need to invest now at a 70o/ointerest rate to fund his retirement goal? 3. Assume that Stephanieaccumulatessavingsof $1 million by the time she retires. If she invests this savings at 8o/", how much money will she be able to withdraw at the end of each year for 20 years? 4. Katelyn plans to invest $2,000 at the end of each year for the next sevenyears. Assuming a 1,4Yo interest rate, what will her investment be worth sevenyears from now? 5. Assuming a 6o/ointerest rate, how much would Danielle have to invest now to be able to withdraw $10,000 at the end of each year for the next nine years? 6. Jim is considering a capital investment that costs $485,000 and will provide the following net cash inflows:

find the NPV of the investment. Usinga hurdlerate of 1.27o, 'S7hat 7. is the IRR of the capitalinvestment described Question6? in P9-38A Retirement planning in two stages (LearningObjectiue 3) You are planningfor a very early retirement. You would like to retireat age40 and haveenoughmoneysaved be ableto draw $225,000per yearfor the next 40 years to (based family historS you think you'll live to age80). You plan to savefor retireon (from age25 to age40) into a fairly ment by making 15 equal annual installments risky investmentfund that you expectwill earn 1,2o/" year.You will leavethe per moneyin this fund until it is completely depleted when you are 80 yearsold. To make your plan work: (Hint: Find the present 1. How much moneymust you accumulate retirement? by valueof the $225,000withdrawals.You may want to draw a time line showing period and the retirement period.) the savings 2. How doesthis amountcompareto the total amountyou will draw out of the How can these investment during retirement? numbersbe so different?

512

Chapter 9

eachyear for the first 15 years? 3. How much must you pay into the investment the 1 (Hint: Your answerfrom Requirement becomes future value of this annuity.) valueat to compare the investment's savings 4. How doesthe total out-of-pocket period and the withdrawalsyou will makeduring the end of the 15-yearsavings retirement? 2,4) P9-39A Evafuate an investment using all four methods (LearningObiectiues 'Water I7orld is consideringpurchasinga water park in San Antonio, Texas,for annualnet cashinflows of $520,000for $1,850,000.The new facility will generate estimatethat the facility will remain useful for eight yearsand eight years.Engineers Its depreciation. ownerswant haveno residualvalue.The companyusesstraight-line usesa paybackin lessthan five yearsand an ARR of 1,0%or mofe. Management of 1.27"hwdle rate on investments this nature. Requirements IRR of l. Computethe paybackperiod,the ARR, the NPV and the approximate this investment.(If you usethe tablesto computethe IRR, answerwith the rate shownin the tables.) interest closest whetherthe companyshouldinvestin this project. 2. Recommend

P9-40A Compare investments with different cash flows and residual values (Learning

2,4) Obiectiues two possible a Locosoperates chain of sandwichshops.The companyis considering plans.Plan A would open eight smallershopsat a cost of $8,440,000. expansion valueat the end of with zeroresidual Expected annualnet cashinflowsare $1,600,000 ten years. UnderPlanB, Locoswould openthreelargershopsat a costof $8,340,000. per net to This plan is expected generate cashinflows of $1,100,000 yearfor ten years, Locosuses valueis $1,000,000. residual Estimated life the estimated of the properties. an and depreciation requires annualreturn of 8o/o. straight-line Requirements 1. Computethe paybackperiod,the ARR, and the NPV of thesetwo plans.What models? of and weaknesses thesecapitalbudgeting arethe strengths Why? plan shouldLocoschoose? 2. Which expansion required IRR comparewith the company's Planlfs IRR. How doesthe 3. Estimate rateof return?

P9-418 Apply capital budgeting to a current event (Leaming Obiectiue1) suchas Forbesor Fortune.Find a magazine, Look through a recentcopy of a business the companythat has recentlymade a capital investment.Summarize company'sdecidecision? Why is this a capitalinvestment sion and then answerthe following questions: V4rat methodsmight the company What effectwill the decisionhaveon the company? lfhat informationwould the companyhaveusedin have usedto make its decision? makingits decision? 3,4) P9-428 Sofve various time value of money scenarios (LeamingObiectiues it just hit the jackpotin Las Vegas If he invests now at a and won $50,000! 1. Curt 15 years? 10olo interestrate,how much will it be worth in

conttnued. . . Decisions and the Time Valueof Money CapitalInvestment 513

z. Nathan would

like to have $1 million saved by the time he retires in 20 years. How much does he need to invest now at a 1.4%" interest rate to fund his retirement goal?

she invests this savingsat 8To, how much money will she be able to withdraw at the end of each year for 15 years?

4. Pam plans to invest $3,000 at the end of each year for the next ten years. Assuming

a 60/" interest rate, what will her investment be worth ten years from now? 5. Assuming a 12"/" interest rate, how much would Carol have to invest now to be able to withdraw $20,000 at the end of each year for the next ten years?

6. Roger is considering a capital investment that costs $1,145,000 and will provide

the following net cash inflows:

Usinga hurdlerate of 1,4'/",find the NPV of the investment. 7. What is the IRR of the capitalinvestment described Question6? P9-438 Retirement planning in two stages (Leaming Objectiue 3) You are planningfor an earlyretirement. You would like to retire at age50 and have enoughmoney savedto be able to draw $225,000 per year for the next 30 years (based family history,you think you'll live to age80). You plan to savefor retireon ment by making 25 equal annual installments (from age25 to age50) into a fairly risky investment fund that you expectwill earn 127" per year.You will leavethe moneyin this fund until it is completely depleted when you are 80 yearsold. To make your plan work: 1. How much moneymust you accumulate retirement? (Hint: Findthepresenr by valueof the $225,000 withdrawals. Youmaywant to draw a time lineshowing savthe ingsperiodandtheretirement period.) 2. How doesthis amountcompareto the total amountyou will draw out of the investment during retirement? How can these numbersbe so different? 3. How much must you pay into the investment eachyear for the first 25 years? (Hint: Your answerfrom Question1 becomes future valueof this annuity.) the 4. How doesthe total out-of-pocket savings compareto the investment's valueat the end of the25-yearsavings period and the withdrawalsyou will makeduring retirement? P9.48 Evaluate an investment using all four methods (Leaming Objectiues 2,4) Zippi manufactures motorizedscooters Oakland,California.The companyis conin sideringan expansion. The plan calls for a construction cost of $5,200,000. The expansion will generate annualnet cashinflows of $675,000for ten years.Engineers estimate that the new facilitieswill remain usefulfor ten yearsand haveno residual value.The companyusesstraight-line depreciation. ownerswant paybackin less Its than five yearsand an ARR of 87. or more. Management usesa hurdle rateof 1,0%" on investments this nature. of

514

Chapter 9

Requirements 1. Computethe paybackperiod,the ARR, the NPV, and the IRR of this investment. 2. Recommend whetherthe companyshouldinvestin this project. P9-458 Gompare investments with different cash flows and residual values (Learning Objectiues 2,4) at plans.PlanA is to openeightcaf6s expansion two Caf6is considering possible Java annualnet cashinflows are $780,000with residual a cost of $4,180,000.Expected value of $820,000 at the end of sevenyears.Under Plan B, Java Caf6 would open net to !2 caf6.s a cost of $4,200,000.This investmentis expected generate cash at years, usefullife of the which is the estimated inflows of $994,000eachyearfor seven is uses straightproperties. valueof the PIanB caf6s zero.JavaCaf6. Estimated residual an line depreciation requires annualreturn of 14%. and Requirements 1. Computethe paybackperiod,the ARR, and the NPV of eachplan. models? of the strengths and weaknesses thesecapitalbudgeting plan should JavaCaf6. adopt?Why? 2. \7hich expansion 'lfhat

are

with JavaCaf6's 3. Estimate IRR for PIanB. How doesPlan B'sIRR compare the requiredrate of return?

515

w DecisionCase

Case 9-46. Apply time value of money to a personal decision (Learning Obiectiue 3) Ted Christensen, second-year a business studentat the Universityof Utah, will graduatein two yearswith an accounting major and a Spanish minor. Christensen tryis ing to decide whereto work this summer. hastwo choices: He work full-time for a bottling plant or work part-time in the accounting departmentof a meat-packing plant. He probablywill work at the sameplacenext summeras well. He is able to work 12 weeksduring the summer. The bottling plant would pay Christensen $380 per week this year and 7"/o more next summer. the meat-packing At plant, he would work 20 hoursper weekat $8.75 per hour. By working only part-time,he would take two accounting courses this summer. Tuition is $225 per hour for eachof the four-hourcourses. Christensen believes that the experience gainsthis summerwill qualify him for a full-time he position with the meat-packing accounting plant next summer. That position will pay $550per week. Christensen seestwo additional benefitsof working part-time this summer. First, he could reduce studyingworkload during the fall and springsemesters his by one courseeachterm. Second, would have the time to work as a graderin the he university's accounting department during the 15-week term. Gradingpays$50 fall per week. Requirements 1. Suppose that Christensen ignoresthe time value of moneyin decisions that coverthis short of a time period. Suppose alsothat his solegoal is to make as much money as possiblebetween now and the end of next summer. What 'Sfhat shouldhe do? What nonquantitative factorsmight Ted consider? would yowdo if you werefacedwith thesealternatives? 2. Now, suppose that Christensen considers time value of moneyfor all cash the flows that he expects receive to one year or more in the future. \X/hichalternative doesthis consideration favor?Why?

516

Chapter9

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Periodsil

l%

3%

4%

5o/"

6%

8%

'i fi%

1 ao/

l4q"

l;. 16o/" |

0.952 0 .9 0 7 0.864 0.823 0 .7 8 4 0.746 0.711, 0.677 0.64s 0 .6 1 4 0 .5 8 5 0 .5 5 7 0 .5 3 0 0 .5 0 5 0 .4 8 1 0 .3 7 7 0.29s 0.231, 0.1,42

0.893 0.797 0.71.2 0.636 0.567 0.507 0.4s2 0.404 0.361, 0.322 0.287 0.257 0.229 0.205 0.1 83 0.104 0.0s9 0.033 0.011

The factors in the table were generatedusing the following formula: I PresentValue of $f : (1. i)" + where: i : annual interest rate a : number of periods

517

H*fuw ffi

PresentValue of Annuity of $1

r0%

0 .98 0 1,.942 2.8 84 3 .80 8 4.71.3 5.6 01 6.472 7 .32 5 8 .1,62 8 .98 3 9 .78 7 0.971, 1.91,3 2.829 3. 71, 7 4. 580 5. 417 6.230 7.020 7. 786 8. 530 9. 253 0. 962 1. 886 2. 77 5 3. 630 4. 4s 2 s.242 6.002 6. 733 7. 435 8. 111 0. 9s 2 1. 859

r6%

0.862 1.605 0.847 1..566

2 3 4 5 6 7

8

il 7.652

9 10 11 13 14 15

20 2s 30 40

8. 7 60 9. 954 9. 385 li 12.134 11,.348 10. 635 9. 986 ti 13.004 1 2.1 06 11..296 10. 563 li 1 3.8 65 12.849 11. 938 11. 118 li 18.046 1 6.3 51 1,4.878 13. 590 li 22.023 1,9.523 1,7.41,3 75. 522

0.833 1.52 8 2 . 4 8 7 2.402 2.322 2.245 2.1,74 2.t06 2.723 3.1,70 3 . 0 3 7 2.91.4 2.798 2.690 2.58 9 3. 546 4. 329 3 . 7 9 1 3 . 6 0 5 3 . 4 3 3 3.274 3 . 1 , 2 7 2.99 1 4 . 3 5 5 4 . 1 . 1 . 1 3 . 88 9 5. 076 4.91,7 1.623 3 . 6 8 5 3 . 4 9 8 3.326 5. 786 5 . 58 2 s.206 4 . 8 6 8 4 . 5 6 4 4.288 4.039 3.872 3.605 6.463 6.210 5.747 5 . 3 3 5 4 . 9 6 8 4 . 6 3 9 4.344 4.078 3.837 s 7.1,08 6.802 6.247 5 . 7 9 5 . 3 2 8 4.946 4 . 6 0 7 4 . 3 0 3 4.031, 7.722 7 . 3 6 0 6.71,0 6.1,45 5 . 6 5 0 5.21,6 4 . 8 3 3 4 . 4 9 4 4.1,92 8. 306 7.887 7 . 1 . 3 9 6.49 5 5.93 8 5 . 5 5 3 5.029 4 . 6 5 6 4.32 7 8. 863 8 . 3 8 4 7 . 5 3 6 6 . 8 1 4 6.1,94 s . 6 6 0 5 . 1 . 9 7 4.793 4.43 9 9. 394 8 . 8 5 3 7 . 9 0 4 7.r03 6.424 5.842 5 . 3 4 2 4 . 9 1 0 4.53 3 9.899 9.295 8.244 7.367 6.628 6.002 5 . 4 6 8 5 . 0 0 8 4.61 , 1 10. 3 80 9.71,2 8 . 5 5 9 7.606 6.81,1, 6 . L 4 2 s . 5 7 5 5 . 0 9 2 4.675 12.462 17.470 9 . 8 1 8 . 5 1 4 7.469 6.623 5.929 8 5 . 3 5 3 4.87 0 9.077 7 . 8 4 3 6 . 8 7 3 6 . 0 9 7 5 . 4 5 7 4.94 8 14.094 12.783 L0.67 5 r 5. 373 1,3.765 1,1,.258 9 . 4 2 7 8 . 0 5 5 7.003 6.1,77 5.51,7 4.979 17. L59 15.046 L1..925 9.779 8.244 7.1,05 6 . 2 3 4 5 . 5 4 8 4.99 7

0.943 1.833 2.673 0.909 1..736

:,

| where: i : annual interestrate z : number of periods

518

Chaot er 9

@8 ft,8

4"* E+?#H#

'

,,11;1; :,,1

1i,,t,,,,:

:'

r' r '1

ao/

t4% 1. 050 1.061 1. 093 1. 082 1. 103 1..1.25 1. 158 1. 216 1. 276 1,.340 1..407 1,.477 1. 551 1.06 0 1,.124 1.'t91, 1,.262 1.338 1,.419 1.504 1.594 1.689 1.080 1.100 1 . . 7 6 6 1,.21,0 1,.260 1 . 3 3 1 1.360 1.464 1,.469 1..61.1. 1.587 1.772 1,.71.4 1,.949 1 . 8 5 1 2.1,44 1..999 2 . 3 5 8 2.1.59 2.594 2.853 3.138 3.452 3.798 4.177 1,.120 1,.254 1.405 1..574 1..762 1..740 1.3 0 0 1,.482 1.689 1,.925

1,6"1 6%

1. 2 3 4 5

b

7 8 9 10 11 12 13 74 15 20 25 30 40

1. 010 1,.020 1. 030 1..041, 1. 051 1,.062 1,.072 1. 083 1,.094 1. 105 1. 116 "t.1,27

1.1 r.1,60

1.3 r.346 1.5 1.531 1..643 1.8 1.811 -1.. 939 2.100 2 .2 8 8 2.1. 2.4 2.436 2 .700 2.8 2.826 3 .1 8 5 3.2 3.278 3 .759 3.8 3.803 4 .435 4.4 4.411. 5 .2 3 4 5.1 5.1,1,7 6 .1,76 5.9 s.936 7.2 8 8

L. 082 L.1,26 1,.r70 1..21.7 1..1.04 I . I 59 1,.265 1,.1.26 r . 194 1.31,6 1,.1.49 I.230 1,.1,72 t . 257 1,.1,9 1. 305 5 L. 2L9 1. 243 1,.268 I.344 1,.384 1. 426 1,.469 1. 513 1. 558 1. 806 2.094

a /11

L. 369 1.423 1. 480 1, . 539 1,.601, 1..665 1. 732 1. 801 2.1,91, 2. 666 3.243

1.974 2.L95 2.21,1, 2 . 5 0 2 2.476 2.853 2.773 3.106 3.479 3.896 4.363 4.887 3.252 3.707 4.226 4.818 s.492

1. 13I 1,.294 1.1,49 1,.31,9 1".1.61.1,.346 L. 220 1,.486 t . 282 1,.641, 1. 348 1 . 81 1 1..489 2.208

1,.797 1. 629 1,.71,0 1 . 8 9 8 2 . 3 3 2 1,.796 2.01_2 2 . 5 1 8 2 . 1 , 3 3 2.720 1. 8 86 1. 980 2.261 2.937 2.079 2.397 3.207 4.292

2.6s3 3.386

3 .2 6 2 4. 80 t

3.172 4.661

t 0.6 6 9 6.8 6.886 8 .599 12.839 7.9 1.47 6.261, 7.988 10. | 5.4 0 7 7.138 9.266 9.2 974 5.474 38 338 9.461 27 3 9 3 9 . 6 4 6 1,3.743 1,9.4 9 - 5 .3 9 6 0.8 1,7.000 26.462 40.874 62. 6 6 9 5.8 2 9 . 9 6 0 5 0 . 9 5 0 85.850 43. 3 7 1 2 3 7 .3 7 6 8 ) 8.7 9 3 . 0 5 1 1 8 8 . 8 4 37 8.721, . 3 7 8 1 , 4 6 9 .7 7 2

The factors in the table were generatedusing the following formula: + Future Valueof $1 : (1. i)" where: i : annual interestrate a : number of periods

519

YmfuB* ffi

3% 1 2 3 4 5 6 7 8 9 10 1.1

11

20y"

13 14 15 20 25 30 40

1 .0 0 0 1. 00 0 1 . 0 0 0 1 . 0 0 0 1.000 1.000 1.000 1.000 1.000 2 .0 5 0 2.060 2 . 0 8 0 2.1,00 2.r20 2.1,40 2.1,60 2.180 2.200 3 .1 .5 3 3.r84 3 . 2 4 6 3 . 3 1 0 3.374 3.440 3.506 3.572 3.640 4.310 4.375 4 . 5 0 6 4.641. 4.779 4.921 5.066 5.215 5.368 5. 309 5 41.6 5 .5 2 6 5. 63 7 5 . 8 6 7 6 . 1 0 5 6.353 6.610 6.877 7.1.54 7.442 6 .1,5 2 6 .30 8 6. 468 6. 633 6.802 6.97s 7.336 7.716 8.115 8.s36 8.977 9.442 9.930 7.21,4 7.434 7. 662 7. 898 8 .7 4 2 8. 39 4 8 . 9 2 3 9.487 10.089 1,0.730 1.1..41.4 12.142 12.91.6 8 .28 6 8 .58 3 8.892 9.21,4 9 .s 4 9 9.897 10.637 1,1,.436 1,2.300 1.3.233 1.4.240 ls.327 1.6.499 9 .36 9 9 75 5 I 0. 159 10. 583 1I.027 11,.497 1 2 . 4 8 8 1,3.579 74.776 16.085 17.51,9 79.086 20.799 1.0.4621 0.9 50 1,1.46412. 006 1 2 .s 7 8 13. 18 1 14.487 1 , 5 . 9 3 7 17.549 19.337 21,.321, 23.s2r 25.959 17.567 7 2.1 .6912. 808 13.486 14.207 1,4.972 7 6 . 6 4 5 1 8 . 5 3 1 20.655 23.045 25.733 28.755 32.750 12.683 1 .3.4 1214.1.9215.026 1 ,s .9 1 716.870 1.8.977 2 1 . 3 8 4 24.1,33 27.271 30.8s0 34.931 39.581 1 3.8 09 14.680 15. 618 16. 627 7 7 .7 1 3 18. 8 82 2 1 . 4 9 5 24.523 28.029 32.089 36.786 42.279 48.497 14.947 1.5.97417. 086 1.8.292 1 .9 .5 9 921. 01 5 2 4 . 2 1 5 2 7 . 9 7 5 32.393 37.581 43.672 50.818 59.196 1 6-0 97 1 7.2 93 1.8599 20. 024 2 1 ..5 7 923.276 2 7 . 1 , 5 2 31 772 37.280 43.842 51,.660 60.965 72.03s 22.01,9 24.297 26. 870 29.778 33.066 36. 78 6 45.762 5 7. 2 7 5 72.052 91".025 115.380 1,46.630 1.86 590 28.243 32 .03 0 36. 459 41..646 47.727 54. 86 5 7 3 . 1 , 0 6 98.347 133.330 181.870 249.210 342.600 471.980 34.785 4 0.5 68 47. 57 56. 085 66.439 79. 05 8 1,1,3.280 5 164.490 24L.330 356.790 530.310 790.950 1,181.900 4 8.8 86 60.402 75.401 95. 026 :1 2 0 .8 01,54.760259.060 4 4 2 . 5 9 0 767.090L,342.000 0 2,360.8004,1,63.200 7,343.900

1.0 00 1.0 00 2.01,0 2.020 3 .03 0 3 .06 0 4.060 4.1 22 5 .10 i 5.2 04 1. 000 1. 000 2. 030 2.040 3. 091 3. 722 4. 1, 84 4.246

The factors in the table were generatedusing the following formula: (l + l )' - I Fu tu reV alue of A nnu i ty o f $ I :

't

52O

Chapter9

e Usrtrtc Tl-83, Tl-83 Plus, Tl-84, on Tl-84 Plus crLculAroRro pERFoRM

TIME VALUE MONEY OF CALCULATIONS: Steps to perform basic present value and future value calculations: menu 1. On the Tl-83Plusor Tl-B4.Plus: Press to IAPPS] showthe applications menu. Press to On the Tl-83or Tl-84: [2nd]lx-l1IENTERI showtheapplications 2. ChooseFinanceto see the finance menu. applications 3. ChooseTVM solver to obtainthe /istof time valueof monev[VM) variables: N : numberof periods(years) l7o: interest rateper year (do not converl percentage to a decimal) PV: presentvalue PMT : amountof eachannuttvinstallment FV = future value P/Y : number of compoundingperiods per year (leave setting at 1) CN = number of couponsper year (leave setting at 7) 4. 5. 6. 7. annuity) PMT:End or Begin(leave settingon End to denotean ordinary Enter the known variablesand set all unknown variablesto zero (except P/Yand C//. whichneed to be left set at 1). you To computethe unknown variable, scroll the linefor the variable want to to solveandthen press [ENTER]. [ALPHA] The answer now appearon the calculator. will -NM solverwhen you are finished.lf you would Press [2nd] IOUIT]to exit the Iike to do more TVM calculations,you do not need to exit. Simply repeat Steps 4 and 5 usingthe new data.

Comments: i. The orderin whichyou inputthe variables doesnot matter. you ii. Theanswer be shown a negative cash will number unless inputthe original as flow data as a negativenumber.Use the IG)lkey to enter a negative number, not the minus key; otherwise you will get an error message.The calculator

continued . . .

follows cash a flow signconvention assumes all positive that that figures cash are inflows and all negative figures cashoutflows. are you iii. The answers get will varyslightly from thosefound usingthe PV and FV tablesin Appendix Why?Because PVand FVfactors the tableshave A. the in beenrounded threedioits. to

Example l: Future value of a lump sum Let's useour lump-suminvestment examplefrom the text. Assume that you invest for five yearsat an interestrate of 6"/".rJsethe following procedures to $10,000 finds its future value five yearsfrom now: 1. On theTI-83 Plusor TI-84 Plus: Press to menu. [APPS] showtbeapplications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] ro show the applications menu. 2. Choose Finance seethe financeapplications to menu. 3. Choose TVM solverto obtainthe listof tirueualueof money(TVM) uariables. 4. Fill in the variables follows: as N:5

r%:6

PV : *10000 (Besure.tousethe negatiue number(-) key,not the mtnusstgn./ PMT:0 FV: 0 PIY :1, CN:1 PMT End or Begin 5. To computethe unknown future value, scroll down to FV and press IALPHA] [ENTER]. 6. The answerwill now appear FV : L3,382.26(rounded). as If you forgot to enterthe $10,000principalas a negative number(in Step4), the FV will be displayed a negative. as Example 2: Future value of an annuityl Let's use the annuity investmentexamplefrom the text. Assumethat you invest The investment earns6olo interest. Use $2,000at the end of eachyear for five years. the following procedures finds the investment's to future valuefive yearsfrom now: 1. On the TI-83 Plusor TI-84 Plus:Press to menu. [APPS] show the applications On the TI-83 or TI-84: Press [2nd] [X-1] IENTER] lo show the applications menu. 2. Choose Financeto seethe financeapplications menu. 3. Choose TVM solverto obtain tbe list of time ualwe money(TVM) uariables. of

522

Chapter9

4. Fill in the variables follows: as N:5 t%:6 PV: O PMT : -2000 (Beswre.to tbe negatiue number(-) key,not the wse mmusstgn.) FV: O P/Y: 1 CX :1, PMT End or Begin 5. To computethe unknown future value, scroll down to FV and press IALPHAI [ENTER]. 6. The answerwill now appear FV : LL,274.19(rounded). as If you forgot to enterthe $2,000 annuity as a negative number (in Step4), the FV will be displayed a negative. as Example 3: Present value of an annuity-Lottery Option #2 Let'susethe lottery payoutOption #2 from the text for our example. Option #2 was to receive $150,000at the end ofeach year for the next ten years.The interestrate valueof this was assumed be 8%. Usethe following procedure find the present to to payout optron: menu. 1. On theTI-83 Plusor TI-84 Plus: Press to IAPPS] sbowtheapplications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] ro show the applications menw.

2. Choose menu. Finance seethe financeapplicdtions to 3 . Choose of TVM solverto obtain the listof time ualwe money(TVM) uariables. 4. Fill in the variables follows: as

N: 10

lo/o: I

PV: O PMT : -L50000 (Besureto usethe negatiue number(-) key,not the mtnussign.) FV:0 PIY :'J. CX :'].. PMT: End or Begin 5. To computethe unknown future value, scroll down to PV and press IALPHAI [ENTER]. (rounded). 6. The answerwill now appearasPV : L,006,512.21 Had we not entered annuity as a negative figure,the presentvaluewould have the beenshownas a negative.

523

Example 4: Present value of a lump sum-Lottery Option #3 Let'susethe lottery payout Option #3 from the text as our example. Option #3 was to receive million ten yearsfrom now. The interestrate was assumed be 8To. to $2 Usethe following procedure find the present to valueof this payout option: 1. On theTI-83 Plusor TI-84 Plus: Press to menu. [APPS] showtheapplications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] ro sbow the applications menu. 2. Choose Finance seethe financeapplications to menu. TYM solverto obtain tbe list of time ualueof money(TVM) uariables. 3. Choose 4. Fill in the variables follows: as N: 10

r%:8

PV: O PMT=0 FV : *2000A00@e sure.towsethe negatiue nwmber(-) key,not the mtnusstgn.) PN=1. CIY :1. PMT End or Begin 5. To computethe unknown future value, scroll down to IIV and press IALPHAI [ENTER]. (rounded). 6. The answerwill now appearasPV = 926,386.98 Had we not entered $2 million future cashflow as a negative, present the the value would havebeenshownas a negative.

NPVGalculations

Ustlc A Tl-83, Tl-83 Pr.us,Tl-84, oR Tl-84 Plus crr-curAToRTo pERFoRM NPV cr-cuLArroNs Steps to performing NPV calculations: lf you arecurrently the TVMsolver in mode,exitby pressing [2nd][Ouit]. 1. On the Tl-83Plus Tl-84Plus: Press or to menu. IAPPS] showthe applications Press On the Tl-83or Tl-84: to menu. [2nd][X-1] IENTERI show the applications 2. ChooseFinanceto see the financeapplications menu. 3. Choosenpv to obtainthe NPVprompt: npv(. 4. Fill in the followinginformation, payingcloseattention usingthe correct to symoors: npv (hurdle rate, initial investment', {cash flow in year 1, cash flow in year 2, etc.)) -the initialinvestment mustbe entered a neqative as number

524 Chapter 9

5. To compute press the NPV, [ENTER]. 6. The answer now appear the calculator. will on 7. To exitthe worksheet, press Alternatively, if you wouldliketo change [CLEAR]. anyof the assumptions sensitivity for you analysis, maypress to [2nd][ENTER] recall formula, the edit anyof the values, then recompute new NPVby and the pressing IENTER]. Note: lf you would liketo find just the presentvalue(notthe NPV)of a streamof unequal cash flows, usea zero(0)for the initial investment.

Example l: NPV of Allegra's GD-player proiect-an annuity Recall that the CD-playerproject required an investmentof $1 million and was expected generate to equal net cashinflows of $305,450eachyear for five years. The company's discount,or hurdle rute,was14yo. 1. On theTI-83 Plusor TI-84 Plus: Press to menu. [APPS] showtheapplications On the TI-83 or TI-84: Press [2nd] [X-1] IENTER] ro show the applicationsrr-tenu. 2. Choose Finance seethe financeapplications to rnenu. 3. Choosenpv to obtain the NPV prompt: npu(. 4. Fill in the following information,payingcloseattentionto usingthe correct symbols: npv (14, -1000000,{305450, 305450,305450,305450,30545A1) @e sureto wsethe negatiue nwmber(-) key,not the minwssign.) 5. To computethe NPV, press[ENTER]. 6. The answerwill now appearon the calculator:48,634.58(rounded). 7. [CLEAR] the worksheet recallit [2nd] [ENTER] for sensitivity or analysis. Example 2: NPV of Allegra's DVD project-unequal cash flows Recallthat the DVD projectrequiredan investment $1 million and was expected of to generate unequalperiodiccashinflows shownin Exhibit 9-14. the 1. On the TI-83 Plusor TI-84 Plus: Press to menu. [APPS] showtheapplications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] ro sbow the applications menw. 2. Choose Finance seethe financeapplications to menu. 3. Choosenpv to obtain the NPV prompt: npu(. 4. Fill in the following information,payingcloseattentionto usingthe correct symbols: npv (14,-1000000,{500000, 350000,300000,250000,40000})(Besure to usethe negatiue number(-) key,not the minwssign.) 5. To computethe NPV, press[ENTER]. 6. The answerwill now appearon the calculator:79,L96.40(rounded). 7. [CLEAR] the worksheet recallit [2nd] [ENTER] for sensitivity or analysis.

Example 3: Investment with a residual value has a residualvalue,simply add the residualvalue as an addiIf an investment For as tional cashinflow in the year in which it is to be received. example,assume we did in Exhibit 9-L2 that the CD project equipmentwill be worth $100,000at an cashinflow to the end of its five-yearlife. This represents additional expected in the company Year5, so we'll showthe cashinflow in Year5 to be $40S,+SO 1: + $305,450 $100,000). Press to ?r7enu. 1. On theTI-83 Plusor TI-84 Plus: [APPS] showtheapplications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] to show the menu. applications menu. Finance seethe financeapplications to 2. Choose 3. Choosenpv to obtain the NPV prompt: npu(. 4. Fill in the following information,payingcloseattentionto usingthe correct symbols: 30"54-50, aA545A]l npv (14, *X000tJ00, 3054,50, 305450, [3054.50, @e nwmber(-) key,not the minussign.) sureto wsethe negatiue 5. To computethe NPV, press[ENTER]. (rounded). 6. The answerwill now appeaton the calculator:100,571.45 or analysis. 7. [CLEAR] the worksheet recallit [2nd] [ENTER] for sensitivity

IRR Galculations

Tl-84, oR Tl-84 Plus crt-culAroRro pERFoRM A Usrruc Tl-83, Tl-83 Pr-us, IRR cllcur-ATroNs identical the procedure to for usedto The procedure findingthe IRRis virtually The only differences that we chooseIRRrather are than NPVfrom find the NPV. a the Finance menuand we don't insert givenhurdlerate. Steps to performing IRR calculations: mode,exitby pressing in lf you arecurrently the TVMsolver [2nd][Ouit]. Press rnenu. or to 1. On the Tl-83Plus Tl-84Plus: [APPS] showthe applications menu. to On the Tl-83or Tl-84:Press [2nd][X-1] IENTER] showthe applications finance applications menu. 2. ChooseFinanceto see the prompt:irr(. 3. Chooseirr to obtainthe /RR payingcloseattention usingthe correct to 4. Fill in the followinginformation, symoors: irr (initial investment*, {cash flow in year 1, cash flow in year 2, etc.}) -the initialinvestment number mustbe enteredas a neqative

E Tn rnmnr r fa th o IR R nrocq f Ft\l TFR l

vvv LE' ! E' ' \1.

will on 6. The answer now aooear the calculator press if you wouldliketo change Alternatively, 7. To exitthe worksheet, [CLEAR]. you for analysis, maypress to anyof the assumptions sensitivity [2nd]IENTER] recallthe formula, edit anyof the values, then recompute new IRR and the by

526 Chapter 9

PrY))[ ry [Lr\ | Lr\J.

Example l: IRR of Allegra's GD-player prciect-an annuity Recall that the CD-playerproject required an investmentof $1 million and was expected generate to equal net cashinflows of $305,450eachyear for five years. Usethe following procedures find the investment's to IRR: 1. On the TI-83 Plusor TI-84 Plus:Press to menu. [APPS] show the applications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] ro show tbe applications menu. 2. Choose Finance seetbe financeapplications to menu. 3. Chooseirr to obtain the IRR prompt: im(. 4. Fill in the following information,payingcloseattentionto usingthe correct symbols: irr (*1000000, (Be 305450,305450,305450,30-5450}) sureto {305450, usethe negatiue nwmber(-) key,not the minussign.) 5. To computethe IRR, press[ENTER]. 6. The answerwill now appear the calculator:16.01 (rounded). on 7. [CLEAR] the worksheet recallit [2nd] IENTER] for sensitivity or analysis. Example 2: IRR of Allegra's DVD proiect-unequal cash flows Recallthat the DVD projectrequiredan investment $1 million and was expected of to generate unequalperiodiccashinflows shown in Exhibit 9-14. Use the folthe lowing procedures find the investment's to IRR: 1. On the TI-83 Plusor TI-84 Plus:Press to menu. [APPS] show tbe applications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] ro sbow the applications menu. 2. Choose Finance seethe financeapplications to menu. 3. Chooseirr to obtain the IRR prompt: irr(. 4. Fill in the following information,payingcloseattentionto usingthe correct symbols: irr (-1000000, 40000})(Beswre 350000,300000,2.50000, to {.500000, usethe negatiue number(-) key,not the minussign.) 5. To computethe IRR, press[ENTER]. 6. The answerwill now appear the calculator:18.23 (rounded). on 7. [CLEAR] the worksheet recallit [2nd] [ENTER] for sensitivity or analysis. Example 3: Investment with a residual value If an investment has a residualvalue,simply add the residualvalue as an additional cashinflow in the year in which it is to be received. example,assume For as we did in Exhibit 9-1"2that the CD project equipmentwill be worth $100,000at the end of its five-yearlife. This represents additional expected an cashinflow to the companyin Year 5, so we'Il show the cashinflow in Year 5 to be $405,450 (: $305,450 $100,000). + L. On the TI-83 Plusor TI-84 Plus: Press to menu. [APPS] showtheapplications On the TI-83 or TI-84: Press [2nd] [X-1] [ENTER] lo show the applications menu.

continued. . . CapitalInvestment Decisions and the Time Valueof Money 527

2. Choose Finance seethe financeapplications to menu. 3. Chooseirr to obtain the IRR prompt: irr(. 4. Fill in the following information,payingcloseattentionto usingthe correct

symbols: irr (-1000000, 305450,30-5450, 305450, 405450i)(Beswre to {305450, usethe negatiue number(-) key,not the minwssign.) 5. To computethe IRR, press[ENTER]. 6. The answerwill now appearon the calculator:17.95 (rounded). 7. ICLEAR] the worksheet recallit [2nd] [ENTER] for sensitivity or analysis.

528

Chapter9

Usttrtc Texls lustnuuerurs l BAll Plus clLculAToR pERFoRM vALUE TIME To

OF MONEY CALCULATIONS Beforeyou start,you need to makea changeto a factory-installed setting. The BAll Pluscomesfrom the factoryassuming monthly, yearly, not compounding of interest. resetthe calculator, To press[2nd]and then fl/Yl.Enter1 (in placeof the factory setting PN : 12) and press Your will yearly [ENTER]. calculator now assume compounding interest. of Press to to l2ndl[AUIT] return a blankscreen. Steps to perform basic present value and future value calculations: 1. Press mode. [2nd][OUIT]to returnto standard-calculator 2. Press TVM] to clearthe TVM(timevalueof money)worksheet. [2nd]ICLR 3. To enterthe TVM value,key in a value and pressthe associatedkey: [N] to enternumberof periods rateper year (do not convertpercentageto decimals) [l/Y]to enterinterest value [PV]to enterthe present [FV]to enter the future value of [PMT]to enterthe amountof eachannualcashinstallment an annuity 4. To computethe unknown TVM value,press[CPT] and then press the keyassociatedwiththe missing press if you aretryingto find the future value(e.g., FV value). 5. The answer now appearon the calculator. will Comments: i. The orderin whichyou inputthe variables doesnot matter. ii. The answer be shownas a negative will you inputthe original numberunless cashflow data as a negative number. Use the I+/-] key to changesigns after you have input the number.The calculator followsa cashflow signconvention that assumes all positive that figures cashinflows are and all negative figuresare cashoutflows. iii. The answers get will varyslightly you from thosefound usingthe PV and FV factors found in AppendixA. Why?Because PVand FVfactorsin the tables the havebeen rounded the nearest to whereas calculators not threedigits, the do truncate the PVand FVfactors. iv. Free, shortonlinevideotutorials the useof thiscalculator be found at for can atomiclearninq.com/ti ba2.

529

Example l: Future value of a lump sum examplefrom the text. Assume that you invest Let's useour lump-suminvestment to $10,000 for five yearsat an interestrate of 6To.Usethe following procedures finds its future value five yearsfrom now: mode. 1. Press [2nd] [QUITI to retwrnto standard-calculator 2. Press [2nd] [CLR TVM] to clearthe TVM worksheet. 3. Enter -10,000; then press[PV] zo enter the curuentcasboutflow for the

tnuestftlent.

Enter 5; then presslNl to enterthe nwmberof periods(years). Enter6; then presslWl to enterthe interestrateper year. 4. Press [CPT] [FV] to find the future ualue. as 5. The answerappears FV : 13,382.26(rounded). numberin Step3 (a cashoutflow for the If you forgot to enter 10,000as a negative as the investment), FV will be displayed a negative. Example 2: Future value of an annuitlr Let's use the annuity investmentexamplefrom the text. Assumethat you invest The investment earns67o interest. Use $2,000at the end of eachyear for five years. future valuefive yearsfrom now: to the following procedures find the investment's mode. 1. Press [2nd] [QUITf to retwrnto standard-calcwlator 2. Press [2nd] [CLR TVM] to cleartbe TVM worksheet. 3. Enter -2,000; then press[PMT] to enter the amowntof eachannuity installment. Enter 5; then presslNl to enterthe nwmberof periods(years). rate per year. Enter 6; then presslIXl to enterthe interest 4. Press [CPT] [FV] to find the fwtureualue. as 5. The answer appears FV : IL,274.19(rounded). If you forgot to input the investmentas a cashoutflow, the FV will appearas a negative number. Option #2 Example 3: Present value of an annuity-Lottery Let's usethe lottery payout Option #2 from the text for our example.The lottery payout Option #2 wasto receive $150,000at the end of eachyear for the next ten to to years. The interest ratewas assumed be 8%. Usethe following procedures find valueof the lottery winnings: the present mode. 1. Press [2nd] [QUITI to retwrnto standard-calcwlator 2. Press [2nd] [CLR TVM] to clearthe TVM worksbeet. 3. Enter-L50,000; then press[PMT] to enterthe amowntof eachannuity installment. Enter 10; then presslNl to entertbe nwmberof periods(years). Enter 8; then press[Wl to enterthe interestrateper year.

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Chapter9

4. Press ualue. [CPT] [PV] to find the present 5. The answerappears PV : t,006,512.21 as Had we not entered annuity as a negative the figure,the present valuewould have beenshown as a negativefigure to indicatethat one would normally have to pay to $1,006,512 receive ten futureinstallments $150,000. the of Example 4: Present value of a lump sum-Lottery Option #o Let's use the lottery payour Option #3 from the text as our example.The lottery payout Option #3 was to receive$2 million ten yearsfrom now The interestrate was assumed be 8oh Usethe following procedures find the present to . to valueof the Iotterywinnings: 1. Press mode. [2nd] [QUIT] to retwrnto standard-calculator 2. Press [2nd] [CLR TVM] to clearthe TVM worksheet. 3. Enter-2,000,000;thenpress[FV] to enterthe fwtwre ualueof the cashflow. Enter t0; then press[Nf to enterthe nwmberof periods(years). Enter 8; then presslUYl to enter the interestrate per year. 4. Press ualwe. [CPT] [PV] to find the present 5. The answerappears PV : 926,386.98 (rounded). as Again,the present valueis positivebecause showedthe future cashflow asnegative. we

NPV Galculations

Usrrrrc TEXAs A lrusrnumerurs Prus calculAToR pERFoRM BAll To NpV

CALCULATIONS 1. Press of [cF] [2nd][cLRwork] to clearthe worksheet allprior information. 2. Press lcFl, enter the investment'sinitial cost as a negative number, and pressIENTER] enter the cost of the investrnent a cashoutflow (CFo). to as 3 . Press to scroll down to the net cash inflow(C01)information. [J] 4 . Enter the net cash inflow that will occur in the first year; then press to IENTER] enterthe firstnet cashinflow from the investment. 5 . Press to scrolldown to the frequency(F01) this cashflow. [J] of 6 . Enter the numberof yearsthat the net cashinflow(co1 that you entered in Step 4) will occur;then press[ENTERI enter the number of vearsthe net to cashinflow will occur. 7. Repeatsteps 3 through 6 only if you arefinding the Npv of an investment with unequal periodicnet cashinflows. B. Press [NPV]. Enter the interest rateat the prompt| :; then press -9. IENTER]. 10. Press to scroll down to the NPVprompt. [J] 11. Press to [CPT] computerhe NPV 12. The answer appearmomentarily. will

CapitalInvestment Decisions the TimeValueof Monev and

Example l: NPV of Allegra's GD-player project-an annuity Recall that the CD-playerproject required an investmentof $1 million and was to equal net cashinflows of $305,450 eachyear for five years. expected generate to discount,or hurdle rate, is t4o/o.Usethe following procedures The company's NPV find the investment's L. Press [CF] [2nd] [CLR \fork] to clearthe worksheetof all prior information. 2. Press[CF], enter-1,000,000, and press[ENTER] to enterthe cost of the inuestment a cashowtflow. as 3. Press to scroll down to tbe net cashinflow (C01) inforrnation. lll 4. Enter 305,450;then press[ENTER] to enterthe first net cashinflow from the inuestment. (F01)information. 5. Press to scroll down to the frequency lll 6. Enter 5; then press[ENTERf to enterthe numberof yearsthe first net cash inflow will occwr. 7. Sincetbe CD-player project is an annuity, all information has beenentered and Steps throwgh6 do not needto be repeated. 3 8. Press [NPV]. 9. Enterthe interestrateat the prompt | : 14; then press[ENTER]. 10. Press to scroll down to the NPV prompt. lll 11. Press [CPT]lo computetheNPV. (rounded). L2. The answerwill appearasNPV : 48,634.58 cash flows Example 2: lrlPV of Allegra's DVD proiect-unequal of Recallthat the DVD projectrequiredan investment $1 million and was expected company's the to generate unequalperiodiccashinflows shownin Exhibit 9-1,4.The to the discount,or hurdle rate, is 1,4oh,Use following procedures find the investment'sNPV of 1. Press [CF] [2nd] [CLR \7ork] to cleartheworksheet all prior information. 2. Press[CF], enter*1,000,000,and press[ENTER] to enterthe cost of the as inuestment a cashowtflou. 3. Press to scroll down to the net cashinflow (C01)information. [J] 4. Enter .500,000; then pressIENTER] to entertbe first net cashinflow from the inuestment. (F01)information. 5. Press to scroll down to the freqwency lll 6. Leaveas L to sbow that the $500,000cashinflow will occuronly once. 7. Sincethe DVD proiect will generatedifferent net cash inflows each year, 3 we must repeatSteps through 6 separately eachyear. for For Year2: 3. Press to scroll down to the cashinflow (C02)information. [J] 4. Enter3,50,000; tbenpress[ENTER] to enterthe cashinflow in Year2. (F02)information. 5. Press to scroll down to the frequency [J] will be receiued only once. 6. Leaveas 1 to show that the 5350,000

532

Chapter9

For Year3: 3. Press to scroll down to the cashinflow (C03)information. [J] 4. Enter 300,000;then press[ENTER] to enter the casbinflow in Year3. (F03)information. 5. Press to scroll down to tbe frequency [J] 6. Leaveas I to show tbat the $300,000will be receiued only once. For Year4: 3. Press b scroll down to the casbinflow (C04)information. [J] 4. Enter 250,00A;then press[ENTER] to enter the cashinflow in Year4. 5. Press tu scroll down to the frequency [J] F04 information. 6. Leaveas I to show that the 8250,000 will be receiued only once. For Year5: 3. Press tu scroll down to the cashinflow (C05) information. [J] 4. Enter40,000;tbenpressIENTER/ to enterthe cashinflow in Year5. (F05)information. 5. Press to scroll down to the frequency [J] 6. Leaveas L to show that tbe $40,000will be receiued only once. 8. Press [NPV]. 9. Enterthe interesttate at the prompt I: 74; then pressIENTER]. 10. Press to scroll down to the NPV prompt. [I] 11. Press [CPT] lo computethe NPV. 12. The answerwill appearasNPV = 79,796.40(rounded). Example 3: Investment with a residual value If an investment has a residualvalue,simply add the residualvalue as an additional cashinflow in the yearin which it is to be received. example, For assume as we did in Exhibit 9-12 that the CD projectequipment will be worth $100,000at the end of its five-yearlife. This represents additional expected an cashinflow to the companyin Year 5 so we'll show the cashinflow in Year 5 to be $405,450 (: $30S,450 $100,000)whereas cashinflows in Years1 through4 are still + the Because yearlycashinflowsareno longerequal,we mustentereach the $305,450. year'scashinflows separately: 1. Press [CF] [2nd] [CLR Work] to clearthe worksheetof all prior information. 2. Press[CF], enter-1,000,000,and pressIENTER] to enterthe cost of the inuestment a cashoutflow. as 3. Press to scroll down to the net cashinflow (C01) information. [I] 4. Enter 305,450;then pressIENTER] to enterthe first net cashinflow from the inuestment, 5. Press to scroll down to tbe freqwency (F01)information. lll 6. Leaveas t to show that the $305,450cashinflow will occuroncein year 1.

continued .

533

7. Sincethe CD project will generatedifferent net cashinflows eachyear,we must repeatSteps3 tbrough 5 separately eacbyear: for For Year2: 3. Press tu scroll down to the cashinflow (C02)information. [J] 0; 4. Enter305,45 thenpress[ENTER] to enterthe cashinflow in Year2. (F02)information. 5. Press to scroll down to the frequency [J] will occuroncein Year2. 6. Leaveas 1 to show that the 5305.450 For Year3: 3. Press n scroll doun to the cashinflow (C03)information. [J] 4. Enter-30-5,45 thenpressIENTER] to enterthe cashinflou in Year3. 0; (F03)information. 5. Press to scroll down to the freqwency [J] will oncein Year 3. 6. Leave I to showthat the 5305.450 occwr as For Year4: 3. Press to scroll down to the cashinflow (C04)information. [J] 4, Enter305,4-501' pressIENTER] to enterthe cashinflow in Year4. then 5. Press to scroll down to the freqwency @0a)information. [J] will occwroncein Year4. 6. Leaveas t to show that the 5305.450 For Year5: 3. Press b scroll down to the cashinflow (C05)information. [J] thenpress[ENTER] to enterthe cashinflow in Year5. 4. Enter405"45A; (F05)information. 5. Press b scroll down to the freqwency [J] will occuroncein Year5. 6. Leayeas I to show that the 5405,450 8. Press [NPV]. 9. Enterthe interestrateat the prompt I : 14; then press[ENTER]. 10. Press to scroll down to the NPV prompt. lIl 11. Press [CPT] lo computethe NPV. (rounded). 12. The answer willappearasNPV : 100,577.45

IRR Galculations

BAll Pt-us To IRR clr-culAToR pERFoRM A Usrruc TExAsllsrnuruerurs

CALCULATIONS identical the procedure to usedto for The procedure findingthe IRRis virtually is the than Theonlydifference that in StepB,we press IRRlkeyrather findthe NPV. rate. key the INPV] and don't entera discount of Work]to clearthe worksheet all prior information. 1. Press [CF][2nd][CLR if Youdo not needto clearthe worksheet you want to find the IRRfor a setof Just reuse the data data you have alreadyentered for an NPVcalculation. alreadystored in the worksheet.

534 Chapter 9

2. Press [CF],enterthe investment'sinitial cost as a negative number, and press to as IENTER] enterthe costof the investment a cashoutflow (CFo). 3. Press b scrolldown to the net cashinflow (C01)information. [J] 4. Enterthe net cash inflow that will occur in the first year; then press[ENTER] to enter the firstnet cashinflowfrom the investment. (F01) 5. Press to scrolldown to the frequency information. [J] 6. Enterthe number of years that the net cashinflow(CO1that you enteredin Step4)will occur;then pressIENTER] enterthe numberof years to the net cashinflow will occur. 7. RepeatSteps3 through 6 only if you are finding the /RRof an investmentwith unequal periodicnet cashinflows. B. Press press to [RR];then [CPT] computethe /RR. 9. The answer appearmomentarily. will Example l: IRR of Allegra's GD-player proiect-an annuity Recall that the CD-playerproject required an investmentof $1 million and was expected generate to equal net cashinflows of $305,450eachyear for five years. Usethe following procedures find the investment's IRR: to 1. Press[CF] [2nd] [CLR'Work] to clear tbe worksheetwnless yow want to reusethe informationalreadystoredin tbe worksheet. 2. Press[CF], enter*1,,000,000, and press[ENTER] to enterthe cost of the inuestment a cashoutflow, as 3. Press to scroll down to the net cashinflow (C01) information, lll 4. Enter 305,450;then pressIENTER] to entertbe first net cashinflow from the inuestment, 5. Press to scroll down to the freqwency (F0L)information. lll 6. Enter 5; then press[ENTEP.] enterthe numberof yearsthe first net cash to inflow will occwr. 7, Sincetbe CD-playerproiectis an annuity,all informationhasbeenentered and Steps throwgh6 do not needto be repeated. 3 8. Press [IRR]; then press[CPT] lo colnputethe IRR. 9. The answerappears IRR : t6.0t (rounded). as Example 2: IRR of Allegra's DVD proiect-unequal cash flows Recallthat the DVD projectrequiredan investment $1 million and was expected of to generate unequalperiodiccashinflows shown in Exhibit 9-14. Use the folthe lowing procedures find the investment's to IRR: 1. Press[CF] [2nd] [CLR Work] to clear the worksheetunlessyou want to rewse informationalreadystoredin the worksheet. the 2. Press[CF], enter-1,000,000,and pressIENTER] to enterthe cost of the inuestment a cashowtflow. as 3. Press to scroll down to the net casbinflow (C01) information. [J] 4. Enter 500,000;then press[ENTER] to entertbe first net cashinflow from the inuestment.

continued. . . CapitalInvestment Decisions and the Time Valueof Money

(F01)information. 5. Press to suoll down to the freqwency lll 6. Enter 1; then press[ENTEP.]to show that tbe $500,000cashinflow will occuronly once. 7. Sincetbe DVD proiect will generatedifferent net cashinflows eacbyear, we must repeatSteps3 tbrowgh6 separately eachyear. for For Year2: 3. Press to scroll down to the casbinflow (C02)information. [J] thenpress[ENTER] to enterthe cashinflow in Year2. 4. Enter3.50,000; (F02)information. 5. Press to scroll down to tbe frequency [J] only once. will be receiued 6. Leaveas I to show that tbe 5350,000 For Year3: 3. Press to scroll down to the cashinflow (C03) information. [J] 4. Enter300,000;thenpress[ENTER] to entertbe cashinflow in Year3. (F03)information. 5. Press to scroll down to the freqwency [J] only once. 6. Leaveas t to show that tbe $300,000will be receiued For Year4: 3, Press to suoll down to the cashinflow (C04) information. [J] thenpress[ENTER] to enterthe cashinflow in Year4. 4. Enter250.00A; 5. Press to scroll down to the freqwency $Ofl information. [J] only once. 6. Leaveas 1.to sbow that the $250,000will be receiued For Year5: 3, Press to scroll down to the cashinflow (C05)information. [J] 4. Enter40,000;thenpressIENTER/ to enterthe casbinflow in Year5. (F05)information. 5. Press to scroll down to the freqwency [J] only 6. Leaveas L to show tbat the $40,000will be recei.ued once. 8. Press [IRR]; then press[CPT] ro computethe lRR. as 9. The answerappears IRR : L8.23(rounded). Example 3: Investment with a residual value procedures we did for findingthe NPV. Simplyadd the residas Usealmostthe same For ual valueas an additionalcashinflow in the year in which it is to be received. will be as example,assume we did in Exhibit 9-1'2that the CD project equipment an worth $100,000 at the end of its five-yearlife. This represents additional expected cashinflow to the companyin Year 5, so we'll show the cashinflow in whereas cashinflowsin the Year5 to be $405,450(: $305,450+ $100,000), the Years1 through 4 are still $305,450.Because yearlycashinflows are no longer 1-7: cashinflows separately. After completing Steps equal,we must entereachyear's 8. Press [IRR]; then press[CPT] lo computetbe IRR. (rounded). as 9. The answerappears IRR : "1.7.95

536

Chapter9

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