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The net present value (NPV) is the total present value of a time series of cash flows. NPV is used to determine what an investment is worth (present value of all cash flows) and how much it costs.

The NPV of an investment is found when cash flows are discounted at the projects required return rate, otherwise known as a discount rate (Emery, Finnerty & Stowe, 2007). Discount rates reflect the riskiness of the expected future cash flows of a project. However, NPV should be calculated using a project specific discount rate due to the wide range of non-diversifiable risks specific to each project.

If a firm uses a single discount rate to compute NPV of a portfolio of projects, it will assume more risk over time. This is because different projects may actually have lower risks or diversifiable risks (that can be eliminated through diversification) or higher risks. In that case, using one discount rate will apply higher risk to otherwise lower risk projects or lower risk to high risk projects masking the actual riskiness of the project. Any decisions made purely using NPV as the criteria may end up being incorrect or inaccurate, which will add more risk to a firm over time. Net present value is the total present value of a time series of cash flows. The net present value (NPV) method discounts all cash flows at the projects require return (Emery, Finnerty & Stowe, 2007). If a company uses this method it is because the projects are independent of each other. The downside to this is that using a single discount rate may show incorrect assumptions based on their

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...before-tax NPV of the new lift and advise the managers of Deer Valley about whether adding the lift will be profitable investment. Show calculations to support your answer. We have to calculate the net present value of cash flows and compare this amount to the cost of investments. Net present value of cash flows (cash inflow – cash outflow) X the factor for PV of cash flows for ordinary annuity of $1 at 14% for 20 years, which is 6.6231 take from PV Table 1. Cash Inflow Additional skiers that the lift will allow x number of days per year when extra capacity will be needed x cost of lift ticket a day Additional skiers that the lift will allow 300 X number of days per year when extra capacity will be needed 40 X cost of lift ticket a day $55 . = Cash Inflow $660,000 Cash Outflow Cost of running the lift per day x number of days the lodge will be open Cost of running the lift per day $500 X number of days the lodge is open 200 . = Cash Outflow 100,000 Present value of net cash flow Net cash flows = cash inflow – cash outflow Cash inflow $660,000 Less Cash Outflow $100,000 = Net cash flows $560,000 Net present value of cash flows Net cash flows x the factor for P V of cash flows for ordinary annuity of $1 at 14% for 20 years is 6.231 taken from PV Table 1 Net Cash flows $560,000 X The factor for P V of cash flows for ordinary...

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...Problems and Solutions 1. Payback Period – Given the cash flows of the four projects, A, B, C, and D, and using the Payback Period decision model, which projects do you accept and which projects do you reject with a three year cut-off period for recapturing the initial cash outflow? Assume that the cash flows are equally distributed over the year for Payback Period calculations. |Projects |A |B |C |D | |Cost |$10,000 |$25,000 |$45,000 |$100,000 | |Cash Flow Year One |$4,000 |$2,000 |$10,000 |$40,000 | |Cash Flow Year Two |$4,000 |$8,000 |$15,000 |$30,000 | |Cash Flow Year Three |$4,000 |$14,000 |$20,000 |$20,000 | |Cash Flow Year Four |$4,000 |$20,000 |$20,000 |$10,000 | |Cash Flow year Five |$4,000 |$26,000 |$15,000 |$0 | |Cash Flow Year Six |$4,000 |$32,000 |$10,000 |$0 | Solution ...

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...The Basics of Capital Budgeting Evaluating Cash Flows ANSWERS TO END-OF-CHAPTER QUESTIONS 13-1 a. The capital budget outlines the planned expenditures on fixed assets. Capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budget. This process is of fundamental importance to the success or failure of the firm as the fixed asset investment decisions chart the course of a company for many years into the future. Strategic business plan is a long-run plan which outlines in broad terms the firm’s basic strategy for the next 5 to 10 years. b. The payback, or payback period, is the number of years it takes a firm to recover its project investment. Payback may be calculated with either raw cash flows (regular payback) or discounted cash flows (discounted payback). In either case, payback does not capture a project's entire cash flow stream and is thus not the preferred evaluation method. Note, however, that the payback does measure a project's liquidity, and hence many firms use it as a risk measure. c. Mutually exclusive projects cannot be performed at the same time. We can choose either Project 1 or Project 2, or we can reject both, but we cannot accept both projects. Independent projects can be accepted or rejected individually. d. The net present value (NPV) and internal rate of return (IRR) techniques are discounted cash flow (DCF) evaluation techniques. These are called...

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...Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 | -100 -100 1 | 10 70 2 | 60 50 3 | 80 20 Project L Project S Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Answer: [Show S11-1 through S11-3 here.] Capital budgeting is the...

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...Chapter 11 The Basics of Capital Budgeting Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 1 2 3 | | | | Project L -100 10 60 80 Project S -100 70 50 20 Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? ...

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...» which distribution channel » should I test market a product Copyright © Michael R. Roberts 2 1 1 Discounted Cash Flows (DCF) A Tool for Rational Decision Making What can be an object of capital budgeting procedures? » There must be a choice - choose a base case and an alternative. (Do nothing/status quo) Identify incremental cash flows from project » Treat as incremental cash flows to shareholder (marginal impact) Calculate the value of the project. » Taking into account timing and risk (t and re) » Aggregate cash flows into one single number Show that doing all and only projects which have positive net present value maximizes the value of the firm. Copyright © Michael R. Roberts 3 Estimating Relevant Cash Flows The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project. Incremental Cash Flows = Firm’s CFs with Project Firm’s CFs without Project Only Incremental Cash Flows are Relevant. But consider, » » » » » » » » Side effects of the project Investment in working capital. Forget about sunk costs. Include all opportunity costs Allocated overhead expenses. Impact on taxes (depreciation & expense) Separate investment from financing decisions Cash flow uncertainty, use expected values Copyright © Michael R. Roberts 4 2 2 Estimating Cash Flows Example A new machine costs $60,000 » » » » installation costs of $2,000. generates revenues of $155,000 and expenses of...

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...Capital Budgeting Analysis Amanda Kocanda, DeUndre’ Rushon, HuongTran,& Morgan Gibreal MBA 612, Financial Strategy October 28, 2014 Bellevue University Abstract Within this paper, an overview of the general capital budgeting process and how it is implemented within organizations is defined and reported. Key terms related to capital budgeting are also defined. Risk analysis based on the Net Present Value (NPV) is performed on the salvage values before and after sales tax values along with the different sale ranges. Keywords: NPV, NPV Profile, NPV, IRR, multiple IRRs, ranking conflict of NPV vs. IRR, payback period, profitability index, discount rate, cost of capital concept, cash flow analysis, cash flow timeline, conventional cash flow stream, non-conventional cash flow stream, sunk cost, opportunity cost, independent projects, mutually exclusive projects Overview of the Capital Budgeting Process Every business requires some source of funds to maintain operation and competitive advantages. Whether it’s a manufacturing or servicing firm, it requires financing. Financing sources can be obtained through debt, bond issuance, bank loan, equity, and issuance of preferred and/or common stock. The amount of debt and equity builds the firm's capital structure. The firm's corporate or business strategy is the proportion of capital structure it needs to finance its operation. The combination of debt and equity totals the cost of capital for the firm. The...

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...Budgeting Learning Objectives 1. Discuss why capital budgeting decisions are the most important decisions made by a firm’s management. 2. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions, and be able to calculate the NPV for a capital project. 3. Describe the strengths and weaknesses of the payback period as a capital expenditure decision-making tool, and be able to compute the payback period for a capital project. 4. Explain why the accounting rate of return (ARR) is not recommended for use as a capital expenditure decision-making tool. 5. Be able to compute the internal rate of return (IRR) for a capital project, and discuss the conditions under which the IRR technique and the NPV technique produce different results. 6. Explain the benefits of a postaudit review of a capital project. I. Chapter Outline 10.1 An Introduction to Capital Budgeting A. The Importance of Capital Budgeting • Capital budgeting decisions are the most important investment decisions made by management. • The goal of these decisions is to select capital projects that will increase the value of the firm. • Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed. • Capital budgeting techniques help management to systematically analyze potential business opportunities in order to decide which are worth...

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...Course Tutor’s Name Date Outline 1. Question I a) Calculation of NPV b) NPV using various discount rates; 7%, 5% and 3% c) Analysis of the graph drawn from the various discount rates 2. Question 2 a) Calculation of Present values using various discount rates; 0%, 2%, 6% and 11% b) Calculation of IRR for the projects c) Calculation of present values using 1%, 4%, 10% and 18% as its discounting rates d) Analysis of the Profitability Index Question I According to Graham and Smart (2011), Net Present value have always been used by many organization and investors in appraising investment projects. Ideally, the calculation of the NPV is provided as follows; a) NPV = Cash flow (1 + r)-n $15,000 = Cash flow (1 + 0.07)-1 PV = $15,000 * 1.07 = $16,050 In the case where the discount rate is decreased to 4%, the current present value will be; NPV = Cash flow (1 + r)-n $15,000 = Cash flow (1 + 0.04)-1 PV = $15,000 * 1.04 = $15,600 b) The analysis of the Present values for the two accounts—Account A and Account B—will be given as follows; i) Account A NPV = Cash flow (1 + r)-n $6,500 = Cash flow (1 + 0.06)-1 PV = $6,500 * 1.06 = $6,890 ii) Account B NPV = Cash flow (1 + r)-n $12,600 = Cash flow (1 + 0.06)-1 PV = $12,600 * 1.06 = $13,356 c) The Net Present...

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...CHAPTER 10 CAPITAL BUDGETING FOCUS Our focus in this first capital budgeting chapter begins with the time value concepts behind methods and then moves on to computational and decision making techniques. The problems of cash flow estimation and risk encountered in practice are touched upon here in anticipation of a detailed treatment in a later chapter. PEDAGOGY A brief overview of the cost of capital concept is presented early in the chapter even though it is the subject of Chapter 13. The knowledge is necessary to understand and motivate the capital budgeting models. It relates NPV - IRR procedures to the required rate of return idea, something with which students are already familiar. We explicitly tie NPV and IRR together by emphasizing that the IRR comes from the NPV equation as the interest rate that sets NPV=0. This helps to develop an overall understanding of both procedures. TEACHING OBJECTIVES After this chapter students should: 1. appreciate the discounted cash flow basis of capital budgeting theory, and 2. be able to make the computations associated with the major capital budgeting techniques. They should also be marginally aware of the difficulties associated with estimating cash flows and differences in project risk. Along these lines, care should be taken not to form the impression that capital budgeting is an engineering-like process that always gives exactly the right answer. OUTLINE I. CHARACTERISTICS...

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...costs and benefits over the project’s life. 3 • Every business would like to do everything • But it all costs • Capital expenditure on new projects or purchases (fixed assets) needs to be planned • Capital is always rationed Scenario: • Your business wishes to expand its product line • It is considering Products A and B but it can only afford to do one. • How does it decide? What main factors affect the investment decision • How much will it cost ? Investment appraisal methods used in practice • How much will I get back ? • When will I get the income ? • 4 main techniques available ranging from simple to moderately complex MULTIPLE APPRAISAL METHODS: Non‐discounted cash flow techniques: 1. Payback period (PBP) 2. Accounting rate of return (ARR/ROCE/ROI) Discounted cash flow techniques(DCF): 3. Net Present Value (NPV) 4. Internal Rate of Return (IRR) 6 1 MBA7001 Accounting for Decision-Makers Week 6 Lecture – Capital Investment Appraisal Objectives (1)...

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...suites Guillermo Furniture. Three Capital Budget Evaluation Techniques-Gerald For Guillermo Furniture, Learning Team A will advise on three different capital budget techniques available to aid in the decision-making process. Those three methods are NPV (Net Present Value), IRR (Internal Rate of Return), and Payback method. NPV (Net Present Value) NPV or net present value helps an organization figure out whether it’s better to invest in a project based on the net amount of discounted cash flows for the project (Eldenburg, PhD & Wolcott PhD, CPA, CMA, 2011). NPV is best served positive which will indicate that the project will be a benefit by increasing the value of the organization. NPV is calculated through expected cash flows that include an initial investment, incremental operating cash flows, and terminal cash flows (Eldenburg, PhD & Wolcott PhD, CPA, CMA, 2011). That calculation is as follows: [pic] Through this calculation, the firm is computing the time period (t), life of the project (n), and the discount rate (r) to reach the NPV. The results as stated earlier if shown to be positive will prove that the project is valuable to the organization. The evaluation for NPV will show to accept if the NPV is greater than zero (Eldenburg, PhD &...

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...Questions 1. Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product because the cash flows are probably harder to predict. 2. With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values. 3. It is true that if average revenue is less than average cost, the firm is losing money. This much of the statement is therefore correct. At the margin, however, accepting a project with marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow. 4. From the shareholder perspective, the financial break-even point is the most important. A project can exceed the accounting and cash break-even points but still be below the financial break-even point. This causes a reduction in shareholder (your) wealth. 5. The project will reach the cash break-even first, the accounting break-even next and finally the financial break-even. For a project with an initial investment and sales after, this ordering will always apply. The cash break-even is achieved first since it excludes depreciation. The accounting break-even is next since it includes depreciation. Finally, the financial break-even, which includes the time value of money, is achieved. 6. Traditional NPV analysis is often too conservative because it ignores profitable options such as the ability to expand the...

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...return. There are two types of project appraisal techniques: non-discounted cash flows and discounted cash flows. The Net Present Value and internal rate of return, examples of discounted cash flows, are in use in many large corporations and regarded as more effective than the traditional techniques of payback and accounting rate of return. In this paper, I will examine the use of the Net Present Value, and the provisions it makes for specific cases, such as unequal lives and mutually exclusive projects. Then I will conclude with the technique that has been proved the best for investment appraisal through the analysis and comparison of project appraisal techniques. The Net Present Value (NPV) method is used by 75% of firms when deciding on investment projects. The reasons for its wide use is that firstly, the NPV rule takes into account the time value of money, meaning that it recognises that a pound today is worth more than a pound tomorrow as the pound today can be invested to start earning interest immediately. Secondly, NPV depends solely on the forecasted cash flows from the project and the opportunity cost of capital. And the final reason for its preference is because the present values are all measured in today’s pounds they have the property of additivity. This property is important as it helps managers to not be misled into accepting a low NPV project just because it is packaged with a high NPV project (Brealey and Myers 116-19). Other reasons for this widely used...

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...1.NPV NPV(Net Present Value), is the present value of a project's cash flow minus the present value of its cost, it means that how much the project could create to shareholders' wealth, the more the NPV, the more value the project makes and the higher the stock's price. If NPV equal to zero means the cash flow which the project makes can compensate for the cost of investment, the rate of return equal to required rate of return. If NPV exceeds zero, the part of exceeded belongs to shareholders. Accept the project which has a positive NPV will create positive economic value added and market value added. In this case, it can be seen clearly from Table 1, SSW and CCS both has a positive NPV, they all create value and wealth for the company. What should be mentioned is that, the NPV of SSW is higher than CCS, it means SSW could add more value than CCS. Table 1. the NPVs of SSW and CCS SSW CCS NPV 240,796.39 226,897.07 2.IRR IRR(Internal Rate of Return ) is the discount rate that make the inflows to equal the initial cost, in other word, it makes NPV to equal to zero. IRR is an estimate of expected project's rate of return. If this return exceed the cost of the capital used to the project, the part of difference is a dividend to shareholders and causes the stock's price to rise. If the IRR is less than cost of capital , shareholders have to make up. In this case, the cost of capital of these two restaurants both equal to 10%, the Table 2 shows that the IRR of SSW is 28.35%...

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