5 calculation questions, 5 concept questions. Prefer answers in word format.

MGMT 613 - Financial Management Module 10 Questions 1. LTC and NPV are two methods for valuating a long term capital expenditure. Please describe a situation where it would be better to use LTC instead of NPV, and then vice versa. Please be specific with the situations. Concept question: Why is it important to consider the cost of long term capital expenditures when they reside on the balance sheet? 2. In the notes that I prepared for you in the Module 9: media and resources section, I gave you an example of calculating NPV. I want you to use that example and calculate what the PV would be if the payments were an equal amount and tell me which one is better and why? Please use the example with 11% required return. Concept question: Why do we calculate the net present value? 3. You have a business that requires the replacement of two 50,000- BTU heating units. Compare the total costs of these units from three manufacturers. Assume that the heaters will be placed in use and will last 10 years. Which company provides heaters with the lowest total cost? Concept question: How might depreciation and tax credits factor into your decision-making process? 4. The Ohm Depot Co. is currently considering the purchase of a new machine that would increase the speed of manufacturing electronic equipment and save money. The net cost of the new machine is $ 66,000. The annual cash flows have the following projections: Year Amount ($) 0 ( 66,000) 1 21,000 2 29,000 3 36,000 4 16,000 5 8,000 If the cost of capital is 10 percent, find the following: The NPV The IRR Payback PI Concept question: What other factors besides the return on investment should you consider when making a major capital purchase? Annuities There are several things that you should know about annuities and how to calculate them. First you need to understand is the following three details: They are for a fixed period of time The rate of return must be consistent for the entire period. The payment amount doesn't fluctuate, vary or change. Using excel for the calculations are pretty simple. If you recall from last week, there are several components in calculating an annuity as follows: PV FV RATE NPER PMT TYPE is present value (when you want to know what the value is in today's dollars) is future value (when you want to know what the value is in tomorrow's dollars) is the interest rate (what is the interest rate that applies) is the number of periods in your calculation (how many periods in your calculation)Note 1 is for any payments (are you making or receiving payments). If there are no payments being made or received just enter 0. is for beginning (denoted by a 1) or end of period (denoted by a 0) What type is referring to is when your payments are made, at the beginning or end of the period. In other words, if you are receiving a monthly payment will you get the payment first in which case there is no time for that payment to earn any interest, or are you getting your payment at the end of the month in which case the funds have a whole month to earn interest before being paid out). If there is no payment involved, just enter 0. Note 1: Please remember that if you are looking for a monthly payment, you will need to make sure that you divide your annual rate by 12. In the case of annuities, we will be using the payment (PMT) function, so you will either have the payment information or you will be solving for the payment information. Let's say you want to know what your payment will be if you invested $10,000 at a rate of 6% for the next 5 years. PMT RATE NPER - PV FV - The payment is what we are solving for. Then stated return for the period is 6%. You will be getting payments each year for the next five years. The present value, or the amount you are starting with, is $10,000. Always remember that the present value needs to be entered as a negative as this is money that is outgoing. The future value is zero because you will be paid each year and there will be completely paid by TYPE: the end of year 5. In this case we are entering zero because the payments are made at the end of the year. If the payments were made at the beginning of the year, we would enter 1. In excel, enter the formula as follows: =PMT(6%,5,-10000,0,0) $2,373.96 What if your company wanted to borrow $775,000 and the repayment schedule calls for thirty annual payments of $50,000 each, what interest rate are you being charged? RATE NPER PV PMT FV TYPE This is what you are solving for. 30 $775,000, in this case you are going to enter the present value as a positive because it money that you are receiving, not paying out. $50,000 (you need to enter as a negative because this is money that you are paying out). 0 because there will be nothing you owe at the end of 30 years. 0 because the payments are made at the end of the period. In excel, enter the formula as follows: =+RATE(30,-50000,775000,0,0) 4.928% What is you wanted to know the monthly payment amount for a thirty year loan of $775,000 at 4.928%? RATE NPER PV FV TYPE 4.928%/12 (because we want to know the monthy payment, not the annual payment. 30 years x 12 payments or 360. $775,000 (enter as a positive because these are the funds you are receiving). 0 as the loan will be paid in full by the end of the 30 year term. 0 because the payments are made at the end of the month. In excel, enter the formula as follows: =PMT(4.928%/12,(30*12),775000,0,0) ($4,126.33) What if you want to pay an additional $5,000 on each annual payment, how much sooner will the loan be paid off? NPER RATE PV PMT FV TYPE This is what we are solving for. 4.928% $775,000 (55,000) 0 0 In excel, enter the formula as follows: =NPER(4.928%,-55000,775000,0,0) 24.643957 Now let's talk for a minute about how important it is to determine whether payments are at the beginning of the period or at the end of a period. What if you had a client who reached their retirement age with $775,000 and wants to liquidate the sum over 20 years starting after year one. If they can earn 5% on their money, how much can they withdraw per year? NPER RATE PV PMT FV TYPE 20 years 5% (775,000) This is what we are solving for 0 0 In excel, enter the formula as follows: =PMT(5%,20,-775000,0,0) $62,188.01 What would happen if that client were to be paid each year at the beginning of the year? NPER RATE PV PMT 20 years 5% (775,000) This is what we are solving for FV Type 0 1 (because the client will receive their payments at the beginning of the year). =+PMT(5%,20,-775000,0,1) $59,226.67 If your client started receiving payments of $62,188, but got them at the start of each year instead of at the end of the year, then they would run out of money before the end of their 20 year term. In excel, enter the formula as follows: Net Present Value (NPV) and Internal Rate of Return (IRR) When it comes to calculating the net present value and internal rate of return, we are always talking about a series of payments that are uneven. After all, if the payment amount was the same we would just calculate the present value of an annuity (we covered that back in module 3). Net Present Value With the NPV, we are looking for a number; whereas with the IRR, we are looking for the return. NPV can be calculated on a financial calculator, in excel, or by hand. NPV is very simply the present value (PV) of Cash inflows minus the present value (PV) of Cash outflows. Let's look at an example. Let's assume that you want to consider an investment of $5,000, and you are currently making 11% on that money. The payments that you will receive over the next 5 years are: Year 1 Year 2 Year 3 Year 4 Year 5 Total $1500 $1000 $ 500 $ 500 $4000 $7500 So in total you will receive $7500. Payments Required rate of return Formula Present Value 0 1 1500 11% =1500/(1.11) 1,351.35 2 1000 11% =1000/(1.11)(1.11) 811.62 3 500 11% =500/(1.11)(1.11)(1.11) 365.60 4 500 11% =500/(1.11)(1.11)(1.11)(1.11) 329.37 5 4000 11% =4000/(1.11)(1.11)(1.11)(1.11)(1.11) 2,373.81 5231.74 So the total present value (PV) of the cash inflows is $5,231.74. Now you need to calculate the present value of the outflows. Since the outflow happened right at the beginning, there is nothing to calculate because it is already in today's dollars. PV of cash inflows Minus PV of cash outflows Net present value $5231.74 (5000.00) 231.74 So what does this mean? When the NPV is positive, it means that the internal rate of return is greater than the required rate of return, and therefore the investment should be accepted. If our required rate of return in this example, were 15%, then the net present value would calculate out to be ($336.17) or $4663.82 minus $5000. In that case you would not accept the investment because you aren't going to achieve your desired result. Payments 0 Required rate of return Present Value - 1 1500 15% 1,304.35 2 1000 15% 756.14 3 500 15% 328.76 4 500 15% 285.88 5 4000 15% 1,988.71 4,663.83 In excel, you enter the formula below: Rate is the required rate of return Value1... are the payments =NPV(rate,value1,value2,value3...) =NPV(11%,1500,1000,500,500,4000) $5,231.74 Please note that excel is giving you the present value of the cash inflows, you still need to subtract the present value of the cash outflow. Take the value calculated above and subtract the PV of the cash outflow 5231.74 -5000 NPV = 231.74 Internal Rate of Return (IRR) IRR is also known as dollar weighted return. IRR measures the total return based on cash inflows and outflows. I have included a sample Excel spreadsheet for calculating IRR, but I wanted to make sure that you understand how to calculate IRR. Personally, I use the dollar weighted return method or my financial calculate far more often because I think they are much easier to use. The dollar weighted return is a very simple spreadsheet to setup, use and understand. The fair market value and expected return are given numbers. To get the weighting of the portfolio you calculate that the stock is of the total and then multiply by the expected return. You repeat for all the investments to get your weighted return. Option A: Dollar Weighted Return Stock A B C Fair Market Value (FMV) 23000 15000 42000 80000 Expected Return 9.50% 12.90% 6.90% % of Portfolio 0.2875 0.1875 0.525 1 Weighted Return 2.73% 2.42% 3.62% 8.77% For, Internal rate of return I prefer to use my HP12C. Although any financial calculator will do, you will just have to look in your manual for the correct sequence. For the HP12C, IRR for the above example would be done as follows: Clear all Key in 9.5 hit enter Key in 23000 hit sigma + (this is the key in the bottom right corner to the left of the + sign) Key in 12.9 hit enter Key in 15000 hit sigma + Key in 6.9 hit enter Key in 42000 hit sigma + Hit the blue g key (located bottom right 3rd from left) Hit XW (the number 6 key) Answer comes up at 8.77 Net Present Value (NPV) and Internal Rate of Return (IRR) When it comes to calculating the net present value and internal rate of return, we are always talking about a series of payments that are uneven. After all, if the payment amount was the same we would just calculate the present value of an annuity (we covered that back in module 3). Net Present Value With the NPV, we are looking for a number; whereas with the IRR, we are looking for the return. NPV can be calculated on a financial calculator, in excel, or by hand. NPV is very simply the present value (PV) of Cash inflows minus the present value (PV) of Cash outflows. Let's look at an example. Let's assume that you want to consider an investment of $5,000, and you are currently making 11% on that money. The payments that you will receive over the next 5 years are: Year 1 Year 2 Year 3 Year 4 Year 5 Total $1500 $1000 $ 500 $ 500 $4000 $7500 So in total you will receive $7500. Payments Required rate of return Formula Present Value 0 1 1500 11% =1500/(1.11) 1,351.35 2 1000 11% =1000/(1.11)(1.11) 811.62 3 500 11% =500/(1.11)(1.11)(1.11) 365.60 4 500 11% =500/(1.11)(1.11)(1.11)(1.11) 329.37 5 4000 11% =4000/(1.11)(1.11)(1.11)(1.11)(1.11) 2,373.81 5231.74 So the total present value (PV) of the cash inflows is $5,231.74. Now you need to calculate the present value of the outflows. Since the outflow happened right at the beginning, there is nothing to calculate because it is already in today's dollars. PV of cash inflows Minus PV of cash outflows Net present value $5231.74 (5000.00) 231.74 So what does this mean? When the NPV is positive, it means that the internal rate of return is greater than the required rate of return, and therefore the investment should be accepted. If our required rate of return in this example, were 15%, then the net present value would calculate out to be ($336.17) or $4663.82 minus $5000. In that case you would not accept the investment because you aren't going to achieve your desired result. Payments 0 Required rate of return Present Value - 1 1500 15% 1,304.35 2 1000 15% 756.14 3 500 15% 328.76 4 500 15% 285.88 5 4000 15% 1,988.71 4,663.83 In excel, you enter the formula below: Rate is the required rate of return Value1... are the payments =NPV(rate,value1,value2,value3...) =NPV(11%,1500,1000,500,500,4000) $5,231.74 Please note that excel is giving you the present value of the cash inflows, you still need to subtract the present value of the cash outflow. Take the value calculated above and subtract the PV of the cash outflow 5231.74 -5000 NPV = 231.74 Internal Rate of Return (IRR) IRR is also known as dollar weighted return. IRR measures the total return based on cash inflows and outflows. I have included a sample Excel spreadsheet for calculating IRR, but I wanted to make sure that you understand how to calculate IRR. Personally, I use the dollar weighted return method or my financial calculate far more often because I think they are much easier to use. The dollar weighted return is a very simple spreadsheet to setup, use and understand. The fair market value and expected return are given numbers. To get the weighting of the portfolio you calculate that the stock is of the total and then multiply by the expected return. You repeat for all the investments to get your weighted return. Option A: Dollar Weighted Return Stock A B C Fair Market Value (FMV) 23000 15000 42000 80000 Expected Return 9.50% 12.90% 6.90% % of Portfolio 0.2875 0.1875 0.525 1 Weighted Return 2.73% 2.42% 3.62% 8.77% For, Internal rate of return I prefer to use my HP12C. Although any financial calculator will do, you will just have to look in your manual for the correct sequence. For the HP12C, IRR for the above example would be done as follows: Clear all Key in 9.5 hit enter Key in 23000 hit sigma + (this is the key in the bottom right corner to the left of the + sign) Key in 12.9 hit enter Key in 15000 hit sigma + Key in 6.9 hit enter Key in 42000 hit sigma + Hit the blue g key (located bottom right 3rd from left) Hit XW (the number 6 key) Answer comes up at 8.77