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

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

3. 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?

4. 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

5. 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

6. 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

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

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

9. 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.

10. $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

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

12. 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
= PV

13. 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

14. 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

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

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

17. 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

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

19. 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

20. 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?

21. 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

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

23. 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

24. 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

25. 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.

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