Week 2 Capital Budgeting


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  • Week 2 Capital Budgeting

    1. 1. Time Value of Money & Capital Budgeting Net Present Value Internal Rate of Return Payback Period
    2. 2. Time Value of Money The Time Value of Money addresses the concept that a dollar is worth more today than it is at a future point in time. This assumption is based on the fact that often times that dollar can be invested and be earn more at some point in time.
    3. 3. Time Value of Money Present Value What is the value of a future cash flow TODAY based on a particular discount (interest) rate ? Future Value What is the value of an amount at a particular time in the future based on a specified interest rate?
    4. 4. Present Value Present Value Formula Future Cash Flow Present Value = n (1 + r) r = discount (interest) rate n = number of time periods
    5. 5. Future Value Future Value Formula n Future Value = Original Amount x (1 + r) r = interest rate n = number of time periods
    6. 6. Capital Budgeting Capital Budgeting is used to help plan for capital expenditures. The main objective of capital budgeting is to maximize the value of the firm. It is designed to answer: Which of several mutually exclusive projects should be selected? How many projects should be selected?
    7. 7. Capital Budgeting Options: Payback Period Net Present Value (NPV) Internal Rate of Return (IRR)
    8. 8. Template Use this template for Assignment #4 ONLY enter data in yellow fields
    9. 9. Cash Flows Initial Outlay of Cash For all calculations, enter future cash flows in the “Income Stream” row for the appropriate year. Year 0 represents the initial cash outlay for the investment/ purchase.
    10. 10. Payback Period (Does not consider the TIME VALUE of MONEY) For Payback period, note when the amount reaches zero in the “payback period” row. This will represent the time in which your initial investment was “paid back.” Keep in mind: The payback period may fall bet ween years. Determine in which year the investment will be paid back.
    11. 11. Net Present Value (NPV) (Considers the TIME VALUE of MONEY) For Net Present Value, you must know the initial investment, future cash flows, and the discount rate. Enter the amounts in the appropriate fields. Net Present Value (NPV) is the summation of the Present Values of all of the future cash flows.
    12. 12. Internal Rate of Return (IRR) (Considers the TIME VALUE of MONEY) IRR % For Internal Rate of Return (IRR), the Net Present Value must be zero. It is often a guessing game when determining the IRR. By trial and error, enter % in the IRR field. Note what the % does to the Net Present Value amount. Continue entering percentages until NPV equals zero (or close to zero).