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10-Capital Budgeting - 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15...

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10model 10/6/2009 8:15 12/2/2002 Chapter 10. Model for Capital Budgeting Tools In this file we use Excel to do most of the calculations explained in Chapter 10. First, we analyze Projects S and L, whose cash flows are shown immediately below in both tabular and time line formats. Spreadsheet analyses can be set up vertically, in a table with columns, or horizontally, using time lines. For short problems, with just a few years, we generally use the time line format because rows can be added and we can set the problem up as a series of income statements. For long problems, it is often more convenient to use a tabular layout. Expected after-tax Project S Year (t) Project S Project L 0 1 2 3 4 0 ($1,000) ($1,000) (1,000) 500 400 300 100 1 500 100 2 400 300 Project L 3 300 400 4 100 600 0 1 2 3 4 (1,000) 100 300 400 600 Capital Budgeting Decision Criteria Here are the five key methods used to evaluate projects: (1) payback period, (2) discounted payback period, (3) net present value, (4) internal rate of return, and (5) modified internal rate of return. Using these criteria, financial analysts seek to identify those projects that will lead to the maximization of the firm's stock price. PAYBACK PERIOD The payback period is defined as the expected number of years required to recover the investment, and it was the first formal method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative cash inflows exceed the initial cash outflows. That is the payback year. Then we take the previous year and add to it the unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the shorter the payback period, the better the investment. Project S Time period: 0 1 2 3 4 Cash flow: (1,000) 500 400 300 100 Cumulative cash flow: (1,000) (500) (100) 200 300 0.00 0.00 0.00 1.00 0.00 Use Logical "AND" to determine 0.00 0.00 0.00 2.33 0.00 the first positive cumulative CF. Payback: 2.33 Use Logical IF to find the Payback. Use Statistical Max function to Alternative calculation: 2.33 Alternative: Use nested IF statements to display payback. find payback. Fx > Logical > IF > OK, statements. Project L Time period: 0 1 2 3 4 Cash flow: (1,000) 100 300 400 600 Cumulative cash flow: (1,000) (900) (600) (200) 400 Payback: 3.33 Uses IF statement. DISCOUNTED PAYBACK PERIOD Discounted payback period uses the project's cost of capital to discount the expected cash flows. The calculation of discounted payback period is identical to the calculation of the regular payback period, except you must base the calculation on a new row of discounted cash flows. Note that both projects have a cost of capital of 10%. WACC = 10% Project S Time period: 0 1 2 3 4 Cash flow: (1,000) 500 400 300 100 Disc. cash flow: (1,000) 455 331 225 68 Disc. cum. cash flow: (1,000) (545) (215) 11 79 Discounted Payback: 2.95 Uses IF statement. net cash flows (CF t ) A B C D E F G H I J 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66
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Project L Time period: 0 1 2 3 4 Cash flow: (1,000) 100 300 400 600 Disc. cash flow: (1,000) 91 248 301 410 Disc. cum. cash flow: (1,000) (909) (661) (361) 49 Discounted Payback: 3.88 Uses IF statement.
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