MAMDMD3b: Determine, represent, and analyze mathematical models for income, expenditures, and various types of loans and investments How do you use capital budgeting to decide what is the most profitable business decision?

My Brother

Best use? Mini Mall or Condos Project A Project B

Project A Project B Year 0 -$200,000 -$400,000 Year 1 $120,000 $60,000 Year 2 $90,000 Year 3 $50,000 Year 4 $40,000 $240,000 Year 5 $30,000 $340,000 K 12% T critical: acceptance level for pay back, must be paid back by this date 2.75 years

Net Present Value Example assume a 5% interest rate Harvard Southeast Missouri State Tuition -208,000 -40,000 First Year 85,000 30,000 Second Year Third Year 115,000 Fourth Year 35,000 Fifth Year Sixth Year

NPV and IRR for making decisions

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments It is not inflation or anything like that

Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital.

Has to do with income streams, the inflows and outflows of cash. We compare the IRR’s of each choice. The one with the higher IRR is more profitable.

Savings Account or buy New Machine Now let's consider an investment that our financial vice president has proposed as an alternative to putting our $1000 in the bank for six years. This investment involves buying a machine that will cost $1000. It will give us $200 in operating profit per year for six years, starting the year after we buy it. At the end of six years, the machine will have no value, due to wear and obsolescence. There's no lump of money waiting for us at the end, as there is with the bank account.

Which option gave us the higher internal rate of return?

The net present value of an income stream is the sum of the present values of the individual amounts in the income stream Tells us how much $ we are really making in terms of current dollars. If profits come sooner, the net present value is higher. If profits come later, the net present value is lower.