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Net present value and the internal rate of return are two methods of capital budgeting.

Both of these methods use time value of money calculations. The consideration of the
time value of money allows the comparison of future cash flows on the date the
investment is expected to be made.
Net Present Value (NPV)
The net present value method (NPV) calculates the dollar value that each future cash
outflow is worth today--i.e., in the present. Using the NPV to evaluate a capital
budgeting project involves the following steps:

Step 1. Draw a time line and label all cash inflows and outflows with the respective
amounts. Display inflows as positive amounts, and outflows as negative amounts in
parentheses.

Step 2. Use the BAII plus professional calculator (or Excel) to calculate the NPV of the
cash flows using the company's required rate of return as the discount rate.

Step 3. Accept or reject the proposed investment based on the following:


If NPV is greater than zero, accept the proposed investment because the
project is expected to generate more than the company's required rate of
return.
If the NPV is zero, accept the proposed investment because the project is
expected to generate exactly the company's required rate of return.
If the NPV is negative, reject the proposed investment because the project
is expected to generate less than the company's required rate of return.
Negative NPV amounts do not imply a loss; they imply only that the proposed
investment is expected to generate less than what management has decided would be
the minimum acceptable return. When comparing two or more possible investments,
the investment with the higher NPV is generally the better choice.

Internal Rate of Return (IRR)


The internal rate of return (IRR) method determines the actual return that a proposed
investment will earn. The IRR is the discount rate that the investment is expected to
earn. Calculating the IRR is a very tedious calculation if attempted manually because it
involves trial and error of multiple interest rates to determine which rate makes the net
present value equal to zero. The IRR method involves the following steps:
Step 1: Draw a time line and label all cash inflows and outflows with the
respective amounts. Display inflows as positive amounts, and outflows as
negative amounts in parentheses.

Step 2. Use the BAII plus professional calculator (or Excel) to calculate the IRR
of the projected investment.

Step 3. Compare the IRR to the company's required rate of return. Accept or
reject the proposed investment based on the following:
If the IRR is greater than the company's required rate of return, accept
the proposed investment.
If the IRR is equal to the company's required rate of return, accept the
proposed investment.
If the IRR is less than the company's required rate of return, reject the
proposed investment.
When the IRR is used in calculating the NPV, the NPV will be zero. Using the IRR
percentage as the discount rate in the NPV calculation will result in a zero NPV.

Using the Texas Instruments' BAII Plus Professional Financial Calculator


The Texas Instruments' BAII Plus Professional (BAII) calculator contains different
worksheets to be used to calculate a number of financial functions. Each worksheet is
preprogrammed for specific financial functions.

Function Modes
Most of the keys on the BAII have two functions--a 'regular' function which is labeled
on the key itself, and a '2nd' function which is labeled just above each key. Pressing
the [2nd] key places a '2nd' symbol in the upper left corner of the display. The [2nd] key
toggles between the regular and the 2nd function mode. Once you are in 2nd function
mode, you can press a key to access any 2nd function, the labels of which are printed
on the calculator just above each key.

Data Entry
Similar to entering data in an Excel worksheet, after you enter each numeric amount
into the BAII worksheet, you must press the Enter key in order to accept and save the
amount. The BAII has arrow keys that enable you to scroll through your entries to
verify the amounts entered. Because the calculator has a continuous memory, any data
entered in a worksheet is saved even when you shut the calculator off.

Conventions
This chapter uses the following conventions when providing directions for keystrokes
on the BAII:
[CF] - Brackets indicate you should press the key with the same name.
e.g., press the [CF] key.

Quit - Blue highlights indicate a '2nd' function found as a label just above
the keys, e.g., press the Quit '2nd' key.
Turn the Calculator On or Off
Press the [On/Off] key to turn the calculator on. Press again to turn off. The calculator
automatically powers off after about 10 minutes.

Set Decimal Places on the Display


The BA II displays 2 decimal places by default. For this course, 5 decimals will meet all
your needs. To change the decimals to 5 places, perform the following keystrokes:
[2nd] Format [5] [Enter] [2nd] Quit
Because the BAII has continuous memory, the change will not be affected by powering
off the calculator. decimals is not necessary.

Calculating IRR and NPV


The Cash Flow Worksheet aids in calculating the internal rate of return (IRR) and net
present value (NPV).
Step 1: Always begin by clearing the Cash Flow worksheet. To do so:
Press [CF] to turn the CF worksheet on.
Press [2nd] CLR Work Quit
Step 2: Press [CF]. The display should show: CF0= 0.00000.
Step 3: Type the numeric amount of the cash flow for time period 'zero'. Then
press [+\-] to change this amount to a cash outflow. The [+\-] key is a toggle key.
Press [Enter].
Step 4: Press the down arrow key to display C01. Type in the cash amount for
period 1, then press [Enter]. Press the down arrow key to display F01. Press
[Enter] to accept the default amount of 1.00000.
Step 5: Press the down arrow key to display C02. Type in the cash amount for
period 2, then press [Enter]. Press the down arrow key to display F02. Press
the down arrow key again to accept F02, and to move to the next field which will
display as C03.
Step 6: Type in the cash amount for each subsequent period in the same
manner. Once all cash flows are inputted, use the up and down arrow keys to
scroll through the Cash Flow worksheet to verify your input.
Either one of the following steps, or both may be performed, depending on if you want
to calculate NPV, IRR, or both.
Step 7: To compute IRR: Press [IRR] then [Cpt]. After a few seconds, the
display should show the IRR percentage.
Step 8: To compute NPV: Press [NPV] to display I = 0.0000. Enter the required
rate of return in decimal format 'as-if' there is a percentage sign following. (e.g.,
7.45) Press [Enter]. Press the down arrow key, then press [Cpt] to display the
dollar amount of the NPV.

Using the Frequency Function


Immediately after entering each cash flow amount in the Cash Flow worksheet in the
BAII calculator, the calculator will display the frequency field, such as F01, F02, and so
on. The letter 'F' stands for frequency. By default, the frequency is set at '1.00000'. The
frequency function is useful in situations where the annual cash flow amount is
expected to be the same numeric amount for multiple years. It allows you to eliminate
typing the same cash amounts individually for multiple years. If the cash flow amount
you entered is expected to be the same for two years, change the frequency from
1.00000 to 2.00000. If the cash flow amount you entered is expected to be the same
for three years, change the frequency from 1.00000 to 3.0000, and so on for the
number of duplicate cash flow periods.

Be cautious, however, because even if you enter a frequency greater than one period,
the next cash flow display will show as the next numeric period, and will not update the
periods to the actual timing of that next cash flow. For example, if you input three
periods in the F01 field, the field will display 3.00000. When you press the down arrow
key, the next field displayed will be C02, though in fact the Cash Flow worksheet is
expecting the cash flow amount for period 4.

Walk Through Example Using the BAII Financial Calculator


Owens is considering whether to buy a new delivery truck costing $60,000. Owens has
an 8.5% required rate of return. Operating cash flows expected for the next four years
to be generated from deliveries to be made with the new truck are as follows:

Year Operating Cash Flows


1 $15,000
2 18,000
3 20,000
4 30,000

Step 1: Press [CF] [2nd] CLR Work Quit. The display should show: CF0= 0.00000.
Step 2: Type in 60000, then press [+\-] to key in the cash flow in year 0, the payment
purchase price of the truck. Press [+\-] to display as a cash flow (negative amount)
cash flow. Press [Enter].
Step 3; Press the down arrow key to display C01. Type in the cash amount for period
1: 15000, then press [Enter]. Press the down arrow key to display F01. Press the down
arrow key to accept the frequency as '1', and to display C02.
Step 4: Type in the cash amount for period 2: 18000, then press [Enter]. Press the
down arrow key and then the down arrow key again to display C03.
Step 5: Type in the cash amount for period 3: 20000, then press [Enter]. Press the
down arrow key and then the down arrow key again to display C04.
Step 6: Type in the cash amount for period 4: 30000, then press [Enter]. Press the
down arrow key.
Step 7: To compute IRR, press [IRR] then [Cpt]. After a few seconds, the display
should read IRR = 12.73549 which tells you that the purchase is estimated to generate
12.74% return per year.
Step 8: To compute NPV, press [NPV] to display I = 0.00000. Enter the required rate of
return as 8.5 and press [Enter]. Press the down arrow key then press [Cpt] to display
NPV = 6,420.4705. The NPV is $6,420 which tells you that the investment will earn
more than the company's required rate of return of 8.5%.
Based on the output, the purchase of the truck should be made.
This page was last edited on Wednesday December 31, 2014 04:39 PM
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