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
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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
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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
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Different IRR Cash Flow Stream
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