Capital budgeting Three dimensions , , 2 Six Models for capital budgeting decisions A B C D E F 3 Discounted Payback Period Formula 4 NPV (Net Present Value Decision Formula 5 IRR (Internal Rate of Return Hurdle Rate Formula 6 Modified Internal Rate of Return Formula 7 Profitability Index Formula Now try your hand with practicing 8 Example Payback period of a new machine Lets say that the owner of Perfect Images Salon is considering the purchase of a new tanning bed It costs $10,000 and is likely to bring in after tax cash inflows of $4,000 in the first year, $4,500 in the second year, $10,000 in the 3 rd year, and $8,000 in the 4 th The firm has a policy of buying equipment only if the payback period is 2 years or less Calculate the payback period of the tanning bed and state whether the owner would buy it or not 9 Example Payback period of a new machine Lets say that the owner of Perfect Images Salon is considering the purchase of a new tanning bed It costs $10,000 and is likely to bring in after tax cash inflows of $4,000 in the first year, $4,500 in the second year, $10,000 in the 3 rd year, and $8,000 in the 4 th The firm has a policy of buying equipment only if the payback period is 2 years or less Calculate the payback period of the tanning bed and state whether the owner would buy it or not Calculate the discounted payback period of the tanning bed, stated in Example 1 above, by using a discount rate of 10 10 Net Present Value A company is considering a project which costs $750,000 to start and is expected to generate after tax cash flows as follows Year 1 $125,000 Year 2 $175,000 Year 3 $200,000 Year 4 $225,000 Year 5 $ 250,000 Discount Rate is 12 11 Using the cash flows for the tanning bed given in Example above calculate its IRR and state your decision CF 0 $10,000 CF 1 $4,000 CF 2 $4,500 CF 3 $10,000 CF 4 $8,000 I or discount rate 10 12 MIRR Using the cash flows given in Example 8 above, and a discount rate of 10 calculate the MIRRs for Projects A and B Which project should be accepted Why 13 Profitability Index Using the cash flows listed in Example 8, and a discount rate of 10 , calculate the PI of each project Which one should be accepted, if they are mutually exclusive Why

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Capital budgeting __________________________________________ Three dimensions , _, 2. Six Models for capital budgeting decisions A. B. C. D. E. F. 3. Discounted Payback Period___________________________________________

Capital budgeting ____________________________________________________

Three dimensions ________________, _____________________, ________________

2. Six Models for capital budgeting decisions

3. Discounted Payback Period_____________________________________________________

Formula

4. NPV (Net Present Value __________________________________________________________

Decision:

Formula:

5. IRR (Internal Rate of Return____________________________________________________

Hurdle Rate __________________________________________

Formula:

6. Modified Internal Rate of Return _______________________________________

Formula

7. Profitability Index ______________________________________________________

Formula

Now try your hand with practicing

Example Payback period of a new machine
Lets say that the owner of Perfect Images Salon is considering the purchase of a new tanning bed.
It costs $10,000 and is likely to bring in after-tax cash inflows of $4,000 in the first year, $4,500 in the second year, $10,000 in the 3^rd year, and $8,000 in the 4^th
The firm has a policy of buying equipment only if the payback period is 2 years or less.
Calculate the payback period of the tanning bed and state whether the owner would buy it or not.

Example Payback period of a new machine
Lets say that the owner of Perfect Images Salon is considering the purchase of a new tanning bed.
It costs $10,000 and is likely to bring in after-tax cash inflows of $4,000 in the first year, $4,500 in the second year, $10,000 in the 3^rd year, and $8,000 in the 4^th
The firm has a policy of buying equipment only if the payback period is 2 years or less.
Calculate the payback period of the tanning bed and state whether the owner would buy it or not.
Calculate the discounted payback period of the tanning bed, stated in Example 1 above, by using a discount rate of 10%.

10. Net Present Value

A company is considering a project which costs $750,000 to start and is expected to generate after-tax cash flows as follows:

Year 1: $125,000

Year 2: $175,000

Year 3: $200,000

Year 4: $225,000

Year 5: $ 250,000

Discount Rate is 12%

11. Using the cash flows for the tanning bed given in Example above calculate its IRR and state your decision.

CF₀ =-$10,000; CF₁ = $4,000; CF₂=$4,500; CF₃ = $10,000; CF₄ = $8,000

I or discount rate = 10%

12. MIRR: Using the cash flows given in Example 8 above, and a discount rate of 10%; calculate the MIRRs for Projects A and B. Which project should be accepted?

Why?

13. Profitability Index : Using the cash flows listed in Example 8, and a discount rate of 10%, calculate the PI of each project Which one should be accepted, if they are mutually exclusive? Why?