Capital Budgeting Techniques (1)

# Cumulative cash flows year 1 2500 2500 cumulative

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Cumulative cash flows Year 1 = \$2,500 = \$2,500 Cumulative cash flows Year 2 = \$2,500 + 1,200 = \$3,700 Cumulative cash flows Year 3 = \$2,500 + 1,200 + 3,000 = \$6,700 Payback period = 2 + (\$5,000 – \$3,700) / \$3,000 Payback period = 2.43 Since project A has a shorter payback period than project B has, the company should choose project A. (if ONLY criteria) 11

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Sample Problems 1. (cont.) b. Discount each project’s cash flows at 15 percent. Choose the project with the highest NPV. Project A: NPV = –\$7,500 + \$4,000 / 1.15 + \$3,500 / 1.152 + \$1,500 / 1.153 NPV = –\$388.96 CFo -7500; CF1 (4000)(F1); CF2 (3500)(F1); CF3 (1500)(F1); I=15; CPT NPV = -\$388.96 Project B: NPV = –\$5,000 + \$2,500 / 1.15 + \$1,200 / 1.152 + \$3,000 / 1.153 NPV = \$53.83 The firm should choose Project B since it has a positive NPV 12
Discounted Payback (DPB)Problem 3. The Discounted Payback Period calculation requires determining the PV of future project CFs: PV of Year 1 cash flow = \$7,000/1.14 = \$6,140.35 PV of Year 2 cash flow = \$7,500/1.142 = \$5,771.01 PV of Year 3 cash flow = \$8,000/1.143 = \$5,399.77 PV of Year 4 cash flow = \$8,500/1.144 = \$5,032.68 The discounted payback (DPB) with \$8,000 initial cost is: 1 + (\$8,000 – 6,140.35)/ 13

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Discounted PB Continued 3. For an initial cost of \$13,000, the discounted payback = 2 + (\$13,000 – 6,140.35 – 5,771.01)/\$5,399.77 = 2.20 years For an initial cost is \$18,000, the discounted payback: = 3 + (\$18,000 – 6,140.35 – 5,771.01 – 5,399.77) / \$5,032.68 = 3.14 years 14
IRR Problem 8. the IRR equation for Project A is: 0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3 0 = – \$2,000 + \$1,000/(1 + IRR) + \$1,500/ (1 + IRR)2 + \$2,000/(1 + IRR)3; OR with calculator CF0 (-2000); CF1 (1000)(F1); CF2 (1500) (F1); CF3 (2000)(F1) IRR = 47.15% 15

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IRR Problem –Project B 0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3 0 = – \$1,500 + \$500/(1 + IRR) + \$1,000/(1 + IRR)2 + \$1,500/(1 + IRR)3 CF0 (-1500); CF1 (500(F1); CF2 (1000)(F1); CF3 (1500)(F1) CPT IRR = 36.19% 16
Different IRR Cash Flow Stream

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