Capital Budget Choices and Excel Functions May 23, 2018 Payback Net Present Value Rate / IRR Cash Flow Time Line How to decide

Q-7 Payback Question 7: If the payback period is two years, which application should be selected?

Payback Wealthy Intuitive managers often use Payback Number of years or months until the return equals the cash investment Often projects have unknown lives How long for a new computer? Truck? Building?

Official Answer: NEVER USE PAYBACK But I have told the board of directors Project has a 4 month payback And we expect it to last 3 to 15 years

Payback The number of years to the nearest 1/10 of a year until cash inflow equals cash outflow Year 0 outflow -$400 cumulative -$400 Year 1 inflow $200 cumulative -$200 Year 2 inflow $200 cumulative $0 Payback at year 2

Payback Applied naïvely brings poor results YET - Intuitive owners are often wise Time value of money - best results Net Present Value Boards “What is the rate of return?” IRR – Internal Rate of Return

Q-2 NPV Question 8: If the required rate of return is 15 percent, which application should be selected?

NPV – Best Net Present Value is best way to evaluate capital spending Creates biggest increase in owner value

Time lines Important Show the timing of cash flows. 1 2 3 i% CF0 CF1 CF2 CF3 Show the timing of cash flows. Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the end of the first period (year, month, etc.) or the beginning of the second period.

$100 Lump Sum inflow due in 2 years Excel Time Line Excel Time Line $100 Lump Sum inflow due in 2 years Period Rate Cash Flow i% 1 2 $100.00

Cash inflow is positive $100 Cash Outflow is negative ($100) -$100

What is the PV of the following uneven cash flow stream? 100 1 300 2 3 10% -50 4 90.91 247.93 225.39 -34.15 530.08 = PV

Solving for PV: Uneven cash flow stream Excel function: PV(rate,nper,pmt,fv,type) Input each cash flow in an Excel PV function: CF1 = PV(0.1,1,0,-100) = $90.91 CF2 = PV(0.1,2,0,-300) = $247.93 CF3 = PV(0.1,3,0,-300) = $225.39 CF4 = PV(0.1,4,0,50) = -$34.15 Add the PV’s for years 1-4 = $530.08

Better Way, USE NPV Rate is 10% Enter value 1, 2, 3, and 4 Notice - No spot for value 0 Important to remember When done, put in negative cash outflow in time zero and add the PV from NPV function

If the investment cost $350 Would you make the investment? NPV from Function +$530.09 Initial Investment -$350 Net Present Value +$180.09

Q-9 Question 9: If the selection criterion is IRR, which application should be selected?

Use Excel IRR function IRR(Values, guess) Can Leave Guess blank Solving for IRR: Use Excel IRR function IRR(Values, guess) Can Leave Guess blank

IRR Needs Cash Flow time line Value 0 = -$350 Value 1 = $100

Check by Computing NPV Use NPV function for cash flow values 1, 2, 3, and 4 Then add the negative cash flow of cash flow zero Answer should be zero NOTE 2 steps required

Which rule is Better? NPV vs IRR Consider two mutually exclusively Investments – Invest $1,000 in new snow plow and expect to earn $500 per year for 5 years Invest $1,000,000 in New Rental Property and Expect to earn $400,000 per year for 5 years?

Results required return 15% IRR Choose the $1,000 snow plow IRR of 41% higher than 29% NPV Choose the $1,000,000 rental NPV of $340,862 higher than $1,500

Q-10 Cash flow time line Question 10: Calculate the expected cash flows from the Android01 project based on the information provided.

Typical Cash flows Initial Investment Negative in year 0 Revenue – Positive in years 1 to n Cash Expense – Negative years 1 to n Salvage Value – Positive in year n Recovery of Working Capital – Positive in year n Cannibalization – Negative Revenue Cannibalization – Positive Expense Tax – Not used in Q-10

Cash Flows – Take it step by step Use excel for cash flows Question 10 is asking for a cash flow time line Easier to do vertically With different items across the top But Will accept either way

Q-11 Question 11: Calculate the NPV for a required rate of return of 6.5 percent. Also calculate the IRR and the Payback Period.

Remember Payback not recommended No spot for Cash Flow Zero in NPV IRR Works but doesn’t maximize wealth