Hope you remember me from earlier in the week.... you needed some additional information to answer question number 1 and question number 2. I've confirmed that the two things being compared is Lowest Total Cost and Net Present Value, different examples of where you would you each and I've attached a PDF for question number 2. Question number 3 requires research on different heating units and the different operating costs for each one.

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? Long term capital expenditures are the expenses that are incurred to expand the earning capacity of a business. These expenditures involve huge expenses in the form of cash outflow and are generally irreversible. The main aim of capital expenditure is to create an asset that will generate income in the future. This investment in the asset is profitable only when the value of expected income from the asset is higher than the cost of asset. Though the asset acquired through capital expenditure will appear in balance sheet but the outflow involve in the assets and the cost of that cash outflow is required to be considered and must be compared with the benefits of the assets. If the benefits of the assets are higher than the cost of assets, then only the investment is profitable. 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? Net Present Value is a technique of capital budgeting. Capital expenditures require huge amount of investment and are expected to generate income over a period of time. Capital expenditures like investment in purchase of asset will likely to provide income in the future throughout the life time of the asset. These benefits from capital investment will occur in future but the cost for the acquisition of the asset is incurred in the present. Therefore, to determine profitability of the investment a comparison between the cost and benefit of the investment is required. This comparison can only be done if the future benefits expected to be derived from the assets during its life time are converted in present value. For converting future benefits into present value, an appropriate discount rate is used and the resultant amount is compared with the present outflow to determine the net present value of investment. Calculation of net present value is essential to know the profitability of the investment. If the net present value is positive, project is profitable otherwise not. 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? Depreciation is the systematic reduction in the book value of the asset and is a non-cash expenses. Main advantage of depreciation is that it is a deductible expense from taxable income. Reductions of depreciation from taxable income reduce tax liability and increases after tax cash inflow because it is non cash expenditure. While making capital expenditure decision a firm must consider the prospective advantage that depreciation can give. Advantage of depreciation depends on two things. First the amount of depreciation permissible to be deducted from taxable income and the second is relevant tax rate. Higher the amount of depreciation in initial years, higher will be the present value of depreciation tax shield. 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 ($) 0 ( 66,000) 1 21,000 2 29,000 3 36,000 4 16,000 5 8,000 If the cost of capital is 10 percent, find the following: The NPV - 20000.77 The IRR - 22.54% Payback - 2.44 Years PI - 1.30 Cost of Capital 10% Year Amount ($) 0 -66000 1 21000 2 29000 3 36000 4 16000 5 8000 Calculation of NPV: 20000.77 Calculation of IRR: 22.54% Calculation of Payback Period: Year Cash Inflow Cumulative Inflow 0 -66000 -66000 1 21000 -45000 2 29000 -16000 3 36000 20000 Payback Period = 2+ 0.444444444 Payback Period = 2.44 Years Calculation of PI: PI = 1 + NPV / Investment PI = 1+ PI = 1.30 0.303041969 Concept question: What other factors besides the return on investment should you consider when making a major capital purchase? While making a major capital purchase, return on investment is a major factor to consider. But there are some other factors also which are required to be considered when making a capital budgeting decision. The first factor apart from return on investment is the likely effect of the project on other projects of the company. Existing projects of the company should not be adversely affected by the new investment. Cost of the capital required for the investment is also a factor to consider. Environmental concern should also be considered when making a capital expenditure. Proposed investment should not have any adverse impact on the environment. Capital purchase may result in increase in existing capacity of the organization. But this should not affect the quality of the products of the company. 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