Time Value of Money Time Value of Money • Increases in value over Increases in value over time/inflation time/inflation • Interest (principle * rate * Interest (principle * rate * time) time) – Simple Simple – Compound Compound • Value in long-term capital Value in long-term capital budgeting decision budgeting decision – Present value Present value – Future value Future value
14
Embed
Time Value of Money Increases in value over time/inflation Increases in value over time/inflation Interest (principle * rate * time) Interest (principle.
Capital Budgeting Methods - not consider time value of money: Payback method - length of time to recover the cost of an investment, cash inflows = initial investment Accounting rate of return – uses cash inflows and depreciation Simple rate of return – net operating income (estimated revenue – estimated costs)
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Time Value of MoneyTime Value of Money
• Increases in value over time/inflationIncreases in value over time/inflation• Interest (principle * rate * time)Interest (principle * rate * time)– SimpleSimple– Compound Compound
• Value in long-term capital budgeting decisionValue in long-term capital budgeting decision– Present valuePresent value– Future valueFuture value
Capital BudgetingCapital BudgetingPlanning process used to determine a firm’s Planning process used to determine a firm’s
long term investmentslong term investmentsLimited resources – efficient use – produce goods Limited resources – efficient use – produce goods
and servicesand servicesPrudent investment decisions – great care, Prudent investment decisions – great care,
deliberate analysisdeliberate analysisCost vs. benefitsCost vs. benefitsCost – current outlay, benefits – future valueCost – current outlay, benefits – future valueMinimum required rate of return – discount future Minimum required rate of return – discount future
cash flows – present valuecash flows – present valueInterest rate to borrow?Interest rate to borrow?Present ROAPresent ROA
Capital BudgetingCapital BudgetingMethods - not consider time value of money:Methods - not consider time value of money:
Payback method - length of time to recover the Payback method - length of time to recover the cost of an investment, cash inflows = initial cost of an investment, cash inflows = initial investmentinvestment
Accounting rate of return – uses cash inflows and Accounting rate of return – uses cash inflows and depreciationdepreciation
Simple rate of return – net operating income Simple rate of return – net operating income (estimated revenue – estimated costs)(estimated revenue – estimated costs)
Capital BudgetingCapital BudgetingPayback method – Payback method –
Easy to do, simple to understandEasy to do, simple to understandShortest route – get back initial capitalShortest route – get back initial capitalDoes not measure the total value of the projectDoes not measure the total value of the project Initial investment/annual cash inflowsInitial investment/annual cash inflowsUsing estimates of yearly profitsUsing estimates of yearly profits I.e. - if a project costs $100,000 and was I.e. - if a project costs $100,000 and was
expected to return $20,000 annually, the payback expected to return $20,000 annually, the payback period would be $100,000/$20,000, or five yearsperiod would be $100,000/$20,000, or five years
Capital BudgetingCapital BudgetingAccounting rate of returnAccounting rate of return
I.e. - if a project costs $100,000 and was I.e. - if a project costs $100,000 and was expected to last 10 years and return expected to last 10 years and return $20,000 annually, the ARR would be $20,000 annually, the ARR would be (20,000-10,000)/100,000 = 10%(20,000-10,000)/100,000 = 10%
Capital BudgetingCapital BudgetingSimple rate of returnSimple rate of return
Annual incremental net operating Annual incremental net operating income/initial investmentincome/initial investment
Capital BudgetingCapital Budgeting If appears to be profitable - more complex capital If appears to be profitable - more complex capital
budgeting analysis is donebudgeting analysis is done NPV - net present value - using expected returns and NPV - net present value - using expected returns and
cost of capital, add value to firm after making the cost of capital, add value to firm after making the required cost of capitalrequired cost of capital
IRR - internal rate of return - equates the estimated IRR - internal rate of return - equates the estimated profits to the cost to see what rate of return actually isprofits to the cost to see what rate of return actually is
NPV = $0NPV = $0
• Oceanic CompanyOceanic Company– Invest in machinery – increase revenue $1 Invest in machinery – increase revenue $1
million/year for next 10 years, cost = $5.6 millionmillion/year for next 10 years, cost = $5.6 million– Present value of $1 million/year for 10 years = Present value of $1 million/year for 10 years =