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# 0730--01 - CAPITAL BUDGETING Present value analyses =>...

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Unformatted text preview: CAPITAL BUDGETING: Present value analyses => Single-period decision models are generally inadequate when decisions affect multiple time periods. Example: 1997 1998 1999 2000 Total Profits under plan 1 ................................................................... \$10,000 \$10,000 \$10,000 \$10,000 \$40,000 Profits under plan 2 ................................................................... (10,000) 20,000 30,000 40,000 80,000 Difference ......................................................................................................... \$20,000 (\$10,000) (\$20,000) (\$30,000) (\$40,000) => Future profits are not as valuable as are current profits since current profits can be invested for a positive return. Example: 1997 1998 1999 2000 Total Profits under plan 3 ................................................................... \$0 \$40,000 \$0 \$0 \$40,000 Profits invested at 5% .......................................................................................... 0 2,000 2,000 2,000 6,000 Plan 3 total .................................................................................................................................. \$40,000 \$2,000 \$2,000 \$2,000 \$46,000 Profits under plan 4 ................................................................... \$0 \$0 \$40,000 \$0 Profits invested at 5% .......................................................................................... 0 0 0 2,000 \$40,000 2,000 Plan 3 total .................................................................................................................................. \$0 \$0 \$40,000 \$2,000 \$42,000 => In business decision-making, the future profits expected under alternative plans must be restated in terms of current monetary units so that the value of the alternative streams of expected profits can be compared on an equivalent basis. => Two general types of future profits (cash flows) that must be restated to present values: Fixed, recurring cash flow amounts (termed "annuities") Singular, nonrecurring cash flow amounts => Present value computations based on tabulated "present value factors": Fixed, recurring cash flows => Present value of annuity tables (PVA). Singular, nonrecurring cash flows => Present value of 1 tables (PV). (See tables on p. 127 of the Jacobs text.) Example: Present value of an annuity 1999 2000 \$10,000 \$10,000 0.864 0.823 Present value ................................................................................................ 8,640 \$35,460 \$9,520 \$9,070 \$ \$8,230 Present value 1997 1998 Using PV table: Profits under plan 1 ................................................................... \$10,000 \$10,000 PV(period,5%) factor ..........................................0.952 0.907 Using PVA table: Profits under plan 1 ................................................................... \$10,000 PVA(4 periods,5%) factor .......................................... 3.546 Present value ................................................................................................ \$35,460 ...
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