Section II-VI 1

II-34

a.k.a. LeanSigma II-36

4 Based on the time value of money principal – comparing what a dollar is worth today to another time period o Payback period o Net present value o Internal rate of return All of these models use discounted cash flows III-20

 Needs to be accounted for in the capital investment decision  Main reason: capital could be used for something else  Capital has an opportunity cost in any given use 5 III-20

 The discounted cash flow (or DCF) describes a method of valuing a project using the time value of money.  All future cash flows are estimated and discounted to give their present values.  The discount rate reflects two things based on risk: ◦ the time value of money – projecting a future value to today’s dollars. ◦ a cost of capital – a corporate charge for using cash. 6 III-20

7 Cash flows should be discounted Lower numbers are better (faster payback) Determines how long it takes for a project to reach a breakeven point III-20

8 A project requires an initial investment of $200,000 and will generate cash savings of $75,000 each year for the next five years. What is the payback period? YearCash FlowCumulative 0($200,000) 1$75,000($125,000) 2$75,000($50,000) 3$75,000$25,000 Divide the cumulative amount by the cash flow amount in the third year and subtract from 3 to find out the moment the project breaks even. III-20

 Advantage ◦ Easy to understand and use ◦ Emphasizes the early recovery of capitol ◦ Cash flow beyond the payback period are uncertain, so they are ignored  Disadvantage ◦ Ignores timing of the cash flow within the payback period ◦ Emphasis is on the recovery of capital, not on profitability ◦ Does not provide a decision criterion for acceptance 9 How do you decide on the maximum allowable payback period? III-20

 One of the most common project selection metrics.  Predicts the change in the firm’s value if a project is undertaken.  We attempt to equate all cash flows to current dollars 10 Higher NPV values are better! A positive value indicate the firm will make money III-20

 NPV takes into account a discount factor  The discount factor is simply the reciprocal of the discount rate 11 III-20

12 Should you invest $60,000 in a project that will return $15,000 per year for five years? You have a minimum return of 8% and expect inflation to hold steady at 3% over the next five years. YearNet flowDiscountNPV 0-$60, $60, $15, $13, $15, $12, $15, $10, $15, $9, $15, $8, $4, The NPV column total is negative, so don’t invest! III-20

 Answers the question: What rate of return will this project earn?  It is the interest rate at which the NPV of the cash flows is equal to zero.  A project must meet a minimum rate of return before it is worthy of consideration.  Need to be solved with MSExcel or a financial based calculator – by hand is an iterative (guessing) process 13 Higher IRR values are better! III-20

14 A project that costs $40,000 will generate cash flows of $14,000 for the next four years. You have a rate of return requirement of 17%; does this project meet the threshold? YearNet flowDiscountNPV 0-$40, $40, $14, $12, $14, $10, $14, $9, $14, $8, $30.30 This table has been calculated using a discount rate of 15% Actual IRR is % The project doesn’t meet our 17% requirement and should not be considered further. III-20

 Definition of motivation on the Web: ◦ the psychological feature that arouses an organism to action toward a desired goal ◦ that which gives purpose and direction to behavior 15 IV-19

 Create a Force Field Analysis for the following proposal ◦ “Earning a graduate degree after completing your bachelors degree” 16 IV-48