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Chapter Thirteen

Capital Budgeting
and Other Time
Value of Money
Applications
Richard E. McDermott, Ph.D.

Capital Budgeting Evaluation Process


Many companies follow a carefully prescribed
process in capital budgeting. At least once a
year:
1) Proposals for projects are requested from
each department.
2) The proposals are screened by a capital
budgeting committee, which submits its finding
to officers of the company.
3) Officers select projects and submit a list of
projects to the board of directors.

Capital Budgeting Evaluation Process


The capital budgeting decision depends on a
variety of considerations:
1) The availability of funds.
2) Relationships among proposed
projects.
3) The companys basic decision-making
approach.
4) The risk associated with a particular
project.

Cash Payback Formula

The cash payback technique identifies the time


period required to recover the cost of the capital
investment from the annual cash inflow produced by
the investment.
The formula for computing the cash payback period
is:

Estimated Annual Net Income from


Capital Expenditure
Assume that Reno Co. is considering an investment of $130,000 in
new equipment. The new equipment is expected to last 5 years. It
will have zero salvage value at the end of its useful life. The
straight-line method of depreciation is used for accounting purposes.
The expected annual revenues and costs of the new product that will
be produced from the investment are:
Sales
Less:

$200,000
Costs and expenses

$132,000

Depreciation expense ($130,000/5)

26,000

Selling and administrative expenses

22,000

Income before income taxes


Income tax expense
Net income

180,000
20,000
7,000
$ 13,000

Computation of Annual Cash Inflow


Cash income per year equals net income plus depreciation
expense.
Annual (or net) cash inflow is approximated by taking net income and adding
back depreciation expense. Depreciation expense is added back because
depreciation on the capital expenditure does not involve an annual outflow
of cash.

Net income

$13,000

Computation of Annual Cash Inflow

Net income
Add: Depreciation expense

$13,000
26,000

Computation of Annual Cash Inflow

Net income
Add: Depreciation expense
Cash flow

$13,000
26,000
$39,000

Cash Payback Period


The cash payback period in this example is therefore
3.33 years, computed as follows:

$130,000

$39,000

3.33 years

When the payback technique is used to decide among acceptable


alternative projects, the shorter the payback period, the more
attractive the investment. This is true for two reasons:
1) The earlier the investment is recovered, the sooner the cash
funds can be used for other purposes, and
2) the risk of loss from obsolescence and changed economic
conditions is less in a shorter payback period.

Review Question
A $100,000 investment with a zero scrap value has an 8-year life.
Compute the payback period if straight-line depreciation is used and net
income is determined to be $20,000.

a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.

Review Question
A $100,000 investment with a zero scrap value has an 8-year life.
Compute the payback period if straight-line depreciation is used and net
income is determined to be $20,000.

a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.

Calculation of answer:
First calculate depreciation:
$100/000/8 years = $12,500
Add depn to income to get net cash flow:
$20,000 + $12,500 = $32,500
Divide investment by yearly cash flow to
get payback period:
$100,000/$32,500 = 3.08 years.

Time Value of Money


Many cost of capital
evaluation techniques
involve time value money
of calculations.
Lets utilize Excel in
learning how to analyze
various investments or
returns involving
incoming or outgoing
streams of money.

A Little Theory . . .
Assume we invest a lump
sum of $100 in time period
zero.

Money

The interest rate is 10% per year.

$300
$200
$100

Time

A Little Theory . . .
We let it grow for three
years.

Money

In one year it is worth


$100 x 1.10 = $110
$133.10
$130

In two years it is worth


$110 x 1.1 = $121
In three years it is worth
$121 x 1.10 = $133.10

$120
$100

Time

A Little Theory . . .
These figures can be calculated using Excel.
Money
Again we are talking about lump sums!

$133.10
$130

The future value of $100 for three


periods at 10% is $133.10.
The present value of $133.10 for three
periods is $100.

$120
$100

This represents the future value and


present value of a lump sum.
0

Time

Practice Problem Future Value of a


Lump Sum

Lets use Excel to work this problem.


This is future value of a lump sum
problem.
We deposit a lump sum of $100, today,
make no additional payments, and leave
the money in the bank for three periods
at 10% per period interest.

Excel Worksheet

Select Formulas

Select Financial

Excel Worksheet

Select FV for future value

Excel Worksheet
This box will appear on your screen.

Excel Worksheet
Notice that we put nothing in the Pmt
box since the $100 is the only deposit.

Excel Worksheet

Hit Ok.
The future value of
$100 for 3 periods at
10% per period is
$133.10.

Another Method
One can also type financial commands into
Excell.
The command for future value is =fv
Enter =fv( and you get the following on
your screen
FV(rate,nper,pmt,[pv],[type])
Entering the values
=fv(.10,3,0,100,0)
The answer given is ($133.10)

Future Value of Lump Sum Problem

Assume you are 25 years of age and


inherit $25,000 from your grandfather.
You decide to save this money for
retirement at age 65.
You deposit it in a certificate of
deposit earning 4% per year.
How much will you have at retirement?
Answer: $120,025.52

Present Value of Future Lump Sum


Lets say you want to leave $1,000,000 to
your great-grandson 100 years from now.
You can invest your money at 10% per year
(compounded monthly).
What lump sum must you invest today to
accrue that amount.
=pv(rate,nper,pmt,[fv],[type])
=pv(.10/12,1200,0,1000000,0)
The answer is $47.32!

Present Value of Future Lump Sum

What if you compound the interest


yearly instead of monthly, does it make
a difference?
Lets see.
This time lets use the menu approach
to solving the Excel problem.

Calculation

From the Excel screen select formulas,


then financial just as we did before.

Now Lets Calculate Present Value

This time
select PV from
the drop down
menu.

This Box Will Appear

Present Value of a Future Lump Sum


Hit OK. The amount you
must deposit today is
$72.57..
Compunding monthly
instead of yearly obviously
makes a difference.

A Little More Theory . . .

A lump sum is one sum of money


invested at some point in time.
We can also have annuities.
An annuity is a series of payments of
the same amount received or paid at
equal periods of time.
$100 invested for 3 periods is an
annuity.

To Illustrate . . .
The first year we make a
payment of $100. That amount
grows with interest until we
make a second payment which
in turn grows with interest until
we make a third payment.

Money
New
Axis

$331

At the end of three years we have


$331 from the annuity.

$300

The future value of 3 payments of


$100 at 10% interest per period is $331

$200
$100

Again, we could calculate this


using Excel.
0

Time

Calculation of Future Value of an Annuity


Problem

Select Formulas

Select Financial

We are still going to use the FV function


However we are going to fill the
pop up box in differently. Now
we will insert $100 in the Pmt
box.

The Answer is $331.00

The same amount shown on the earlier


chart!

What does this mean?

If you deposit three yearly payments of $100


each, at the end of three years you will have
$331.00 in savings.

Practice Problem

An individual saves $500 a month for


thirty years at 8% interest a year.
How much will he have in savings at the
end of thirty years?

Things to Be Aware of
Make sure you pay attention to the fact
that the money is deposited in savings
monthly.
The pop-up box, interest, periods, and
payments must all be consistent.
The interest rate will not be .08 but .
08/12 months = .006667.
The number of periods will be 30 years x
12 months = 360.

Calculation

From the menu at the top of the


screen, select Formulas and then
Financial just as we have before.
Select FV as before, and fill the box
that appears in as shown on the
following screen:

Pop-up Box

The Answer is:


At the end of thirty
years, you will have
$745,785.11 in the
bank!
Again, this problem is a
future value of an annuity
problem. The annuity is
$500 per month.

Now Lets do a Present Value of an


Annuity
Your daughter is going away to college.
Living expenses and tuition and books will
cost $33,000 for six years (she wants to
get a graduate degree)
You can invest money at 7% a year.
How much must you deposit today so that
she can draw out $33,000 a year six years
earning a 7% return on money in the bank?

Present Value of An Annuity

Select Formulas and Financial from the


Excel menu as before.
Select PV as before (remember PV and
FV can be used for both lump sums and
annuities).
You will get the following pop-up box.

Present Value of an Annuity

Hit ok. The answer is $157,296.81!

PV and FV Functions
With the PV and FV functions, we can
combine and annuity and a lump sum
calculation.
For example, assume you have $25,000 to
deposit in the bank today at 6%.
Then for the next ten years you will
deposit $5,000 a year at 6%.
How much will you have (what will the
future value be) at the end of ten years?

Future Value of a Lump Sum and Annuity

Select Formulas, and Financial as


before.
Select FV to get the following box.

The answer is . . .

$70,339.57

Discounting Cash Flows that Are Not


Equal

Earlier we said that an annuity was a


series of equal payments, equally
spaced.
What if we are to receive payments
that are unequal in amount but equally
spaced?
How do we find the present value?

Discounting Cash Flows that Are Not


Equal

Why do we care?
Because this is one way of valuing a
business!

Why We Care

Most business valuations are done by


discounting projected cash flows.
Also, stocks, bonds, and businesses are
valued by taking the present value of
future cash flows.
Lets do some examples.

Valuing a Business

You are looking at purchasing a small


jewelry store from your brother-in-law.
The business will grow each year.
You forecast the cash inflows from the
business for the next ten years (shown
on the next slide).

Projected Cash Flow


Today

Valuing a Business

At the end of ten years you will close


the business and sell the equipment for
$10,000 (scrap value).
Assume you could invest money
elsewhere, in an investment with
approximately the same risk, for 12%
annual return.
What is the jewelry store worth?

Solution

We could select Formulas, Financial, and


NPV, at which time we would get a pop
up box into which we would enter the
values, or . . .
In this case it might be easier to write
out the formula in an Excel cell.
The formula is:
=npv(rate, value 1, value 2 . . .)

Lets See What it Looks Like on The


Excel Sheet

Note: the last cash flow consists of the $15,000


from operations plus the $10,000 salvage value
of the equipment when the Laundry is sold.
The answer is $184,238.35.

Lets Do the Same Thing Using the Popup Box

Select from the


menu at the top of
the page,
Formulas, and then
Financial, as we
have done before.
Then select from
the drop down box
NPV.

The Answer is the Same!


Note
that all
of the
values
are not
shown
on this
copy of
the popup box.

What this Means


What this means is that if you wish to earn
12% a year, you should pay no more than
$184,238.35 for this business.
If you pay more than that, you will
earn less than your desired 12% rate
of return.

How Much Less

Lets assume you actually pay $200,000


for the shop.
Assuming the projected cash flows are
correct, what will be your actual rate of
return?
To determine this we will use the
internal rate of return (IRR) function.

Lets First Make a Table of Projected


Cash Flows That Looks Like This

Now Lets Go To The Menu Like We Did


Before . . .

Select Formulas from the top menu bar


Then Select Financial
Select IRR

Your pop-up box will look like this

Drag and drop the cash flows from the Excel Spreadsheet into the
values box.

You are required to give a guess as to


what the IRR will be

The actual rate of return is approximately


10.15%

Net Present Value

There is one more concept we should talk


about when talking about discounting cash
flows.
The concept is net present value.
Net present value discounts at a
specified interest rate both cash
outflows (i.e. the initial investment) and
inflows from operations to give a total
value.

Net Present Value


One of the things I dont like about Excel is
that it uses the term net present value to mean
the cash flows from periods 1 though X (in
other words the investment in period 0 is not
included in the net present value calculation.
Time period 0 is, however, included in the
calculation of net present value.
It is best to illustrate what I am saying with an
actual problem.

Example

Community Hospital is considering


building an outpatient surgery center.
The hospital can borrow money to build
the center ($2,000,000) for 14%.
The 14% is the required rate of return
that will be used in determining whether it
will accept or reject a project.

Example

Given the cash flow


schedule on the right,
calculate the net
present value at 14%.
Today we invest $2,000,000. Today is always period 0.
The first year we have a loss of $40,000.

Time
Period Cash Flow
0 -2000000
1
-40000
2
-20000
3
-10000
4
100000
5
400000
6
600000
7
800000
8 1000000
9 1500000
10 1800000

In Excel the calculation is a two step process. First we use NPV to determine the net
present value of cash flows in periods 1 through 10. Then we add the present value of
$2.000.000 today (which of course is $2,000,000) to get the net present value.
Lets do it!

Solution

=npv(rate, value 1, value 2, . . .)


=npv(.14,-40000,-20000,10000,100000,400000,600000,800000
,1000000,1500000,1800000)
Answer = $2,100,150.32.
Now add this to the present value of
$2,000,000 today to get a net present
value of $100,150.32!

Solution

What does the $100,050.32 mean?


It means that the hospital will earn
$100,050.32 in addition to a 14% return
on the $2,000,000.

Solution

Okay, so what is the actual rate of


return?
We cannot use =irr(values, guess) to
calculate this as Excel does not allow
these many functions when typing in the
formula.
Instead we must use the drop down
menus and drag and drop the range of
values.

Solution
Time
Period Cash Flow
0 -2000000
1
-40000
2
-20000
3
-10000
4
100000
5
400000
6
600000
7
800000
8 1000000
9 1500000
10 1800000

Select
formulas

Solution

Select
Insert
Function

Select IRR

Solution

Although it is hard to see using PowerPoint, when I drag and drop the values
into the values box, I do include the value for time period 0.
The answer you should receive is 14.6957%!

Review: All of this illustrates the theory behind


the discounted cash flow techniquea technique
based on the time value of money.

Discounted Cash Flow Technique


S

The discounted cash flow technique is


generally recognized as the best conceptual
approach to making capital budgeting decisions.
This technique considers both the estimated
total cash inflows and the time value of money.
As discussed, the two methods used with the
discounted cash flow technique are:
1) net present value and
2) internal rate of return

Net Present Value Method


Under the net present value method, cash
inflows are discounted to their present value
and then compared with the capital outlay
required by the investment.
The interest rate used in discounting the
future cash inflows is the required minimum
rate of return.
A proposal is acceptable when NPV is zero or
positive.
The higher the positive NPV, the more
attractive the investment.

Additional Considerations

The previous NPV example relied on


tangible costs and benefits that can be
relatively easily quantified.
By ignoring intangible benefits, such as
increased quality, improved safety, etc.
capital budgeting techniques might
incorrectly eliminate projects that
could be financially beneficial to the
company.

Additional Considerations
To avoid rejecting projects that actually should be
accepted, two possible approaches are suggested:
1. Calculate net present value ignoring intangible
benefits. Then, if the NPV is negative, ask
whether the intangible benefits are worth at least
the amount of the negative NPV.
2. Project rough, conservative estimates of the
value of the intangible benefits, and incorporate
these values into the NPV calculation.

Profitability Index

Another way of evaluating competing


capital projects is through the
profitability index.
The formula for the profitability index
is: calculated by taking the present
value of the net cash flow and dividing
it by the initial investment.

Profitability Index
Assume we are evaluating two projects, projects A and
B.
The initial investment of Project A is $40,000, and the
initial investment of Project B is $90,000.
Also assume that we have calculated the present value
of net cash flows for each project.
The present value of Project A is $58,112, and the
present value of Project B is $110,574.
What is the profitability index of each project?

Profitability Index
Present Value of Net Cash

Flows

Initial Investment
=

Project A
Present Value
of Net Cash
Flows

$58,112

Profitability
Index

Project B
$110,574

The Profitability Index


Present Value of Net Cash
Flows

Initial Investment

Project A
Present Value
of Net Cash
Flows
Divide by
Initial
Investment
Profitability
Index

Profitability
Index

Project B

$58,112

$110,574

$40,000

$90,000

1.4528

1.2286

Profitability Index

In the previous slide, the profitability


index of Project A exceeds that of
Project B.
Thus, Project A is more desirable.
If the projects are not mutually
exclusive, and if resources are not
limited, then the company should
invest in both projects, since both
have positive NPVs.

Review Question
Assume Project A has a present value of net cash inflows of $79,600
and an initial investment of $60,000. Project B has a present value of
net cash inflows of $82,500 and an initial investment of $75,000.
Assuming the projects are mutually exclusive, which project should
management select?

a.

Project B.

b. Project A or B.
c. Project A.
d. There is not enough data to answer the question.

Review Question
Assume Project A has a present value of net cash inflows of $79,600
and an initial investment of $60,000. Project B has a present value of
net cash inflows of $82,500 and an initial investment of $75,000.
Assuming the projects are mutually exclusive, which project should
management select?

a.

Project B.

b. Project A or B.
c. Project A.
d. There is not enough data to answer the question.

Post-Audit of Investment Projects


Performing a post-audit is important for
a variety of reasons.
1. If managers know that their estimates will be
compared to actual results they will be more likely
to submit reasonable and accurate data when
making investment proposals.
2. A post-audit provides a formal mechanism by which
the company can determine whether existing
projects should be supported or terminated.
3. Post-audits improve future investment proposals
because by evaluating past successes and failures,
managers improve their estimation techniques.

Annual Rate of Return Formula


The annual rate of return technique is based on
accounting data. It indicates the profitability
of a capital expenditure. The formula is:

The annual rate of return is compared with its required


minimum rate of return for investments of similar risk.
This minimum return is based on the companys cost of capital,
which is the rate of return that management expects to pay on
all borrowed and equity funds.

Formula for Computing


Average Investment
Expected annual net income ($13,000) is obtained from
the projected income statement. Average investment is
derived from the following formula:

For Reno, average investment is $65,000:


[($130,000 + $0)/2]

Solution to Annual Rate of Return Problem


The expected annual rate of return for Reno Companys
investment in new equipment is therefore 20%, computed
as follows:

$13,000 $65,000 = 20%


The decision rule is:
A project is acceptable if its rate of return is greater than managements
minimum rate of return. It is unacceptable when the reverse is true.
When choosing among several acceptable projects, the higher the rate of
return for a given risk, the more attractive the investment.

Review Question
Bear Company computes an expected annual net income from an
investment of $30,000. The investment has an initial cost of $200,000
and a terminal value of $20,000. Compute the annual rate of return.

a. 15%.
b. 30%.
c. 25%.
d. 27.3%.

Review Question
Bear Company computes an expected annual net income from an
investment of $30,000. The investment has an initial cost of $200,000
and a terminal value of $20,000. Compute the annual rate of return.

a. 15%.
b. 30%.
c. 25%.
d. 27.3%.

Review Problem 1

Marcus Company is considering


purchasing new equipment for
$450,000.
It is expected that the equipment will
produce net annual cash flows of
$55,000 over its 10-year useful life.
Compute the cash payback period.

Review Problem 1

Net cash flow is already calculated


($55,000).
If it were not, one would add annual
depreciation to net income to calculate it.

Divide investment by cash flow:


$450,000/$55,000 = 8.2 years

Review Problem 2
Jacks Custom Manufacturing Company is
considering three new projects, each requiring
an equipment investment of $21,000.
Each project will last for 3 years and produce
the net annual cash flows shown below:
Year

AA

BB

CC

$7,000

$9,500

$13,000

9,000

9,500

10,000

15,000

9,500

11,000

Total

$31,000

$28,500

$34,000

Review Problem 2

The equipments salvage value is zero.


Jack uses straight-line depreciation.
Jack will not accept any project with a
cash payback period over 2 years.
Jacks required rate of return is 12%.
Compute each projects payback period,
indicating the most desirable and least
desirable project using this method.

Review Problem 2
Lets do project AA first:
The first years cash flow is $7,000 as shown on
the chart.
The second years cash flow is $9,000 which
brings the cumulative cash flow to $16,000.
At the end of the third year we only need
$5,000 to reach payback.
It takes $5,000/$15,000 = .33 of a year to get
this cash.
The payback period, therefore, is 2.33 years

Review Problem 2

Using the same methodology we get


2.21 years for project BB, and 1.8 years
for project CC.
The most desirable project is CC
because it has the shortest payback
period.
The least desirable is AA because it
has the longest payback period.

Review Problem 2

Compute the net present value of each


project. Does your evaluation change?

Review Problem 2

Which project is therefore most


desirable?
Project CC since it has the highest NPV
of $6,409.
The least desirable project is BB with a
NPV of $1,817.

Review Problem 3
Mane Event is considering a new hair salon in
Pompador, California.
The cost of building a new salon is $300,000.
The new salon will normally generate annual
revenues of $70,000 with annual expenses
(excluding depreciation) of $40,000.
At the end of 15 years, the salon will have a
salvage value of $75,000.

Review Problem 3
Okay, since depreciation is included in the
expenses, we can expenses as given from
revenues to get accounting income.
Remember, we need accounting income for
annual rate of return, not cash flows as with
NPV.
Annual income is $70,000 - $40,000 = $30,000.
The average investment is calculated using the
following formula:
(Investment + Salvage Value)/2

Review Problem 3

So the average investment is:


($300,000 + $75,000)/2 = $187,50

So annual rate of return is:


Income $30,000/Avg. Investment
$187,500 = 16%

Review Problem 4

Jo Quick is managing director of Tot


Lot Day Care Center.
Tot Lot is currently set up as a fulltime child care facility for children
between 12 months and 6 years old.

Review Problem 4

Jo Quick is trying to determine


whether the center should expand its
facilities to incorporate a newborn care
room for infants between the ages of 6
weeks and 12 months.

Review Problem 4

The necessary space already exists.


An investment of $200,000 would be
needed, however, to purchase cribs,
high chairs, etc.
The equipment purchased for the room
would have a 5-year useful life with
zero salvage value.

Review Problem 4

The newborn nursery would be staffed


to handle 11 infants on a full-time basis.
The parents of each infant would be
charged $125 weekly, and the facility
would operate 52 weeks of the year.
Staffing the nursery would require two
full-time specialists and five part-time
assistants at an annual cost of $60,000.

Review Problem 4

Food, diapers, and other miscellaneous


items are expected to total $6,000
annually.

Review Problem 4

Determine the net income and annual


cash flows for the nursery.

Review Problem 4

Fee revenues

11 x $125 x 52

Annual Net
Income

Annual
Cash Flow

$71,500

$71,500

Calculation of Income and Cash Flow

Review Problem 4

Fee revenues

Annual Net
Income

Annual
Cash Flow

11 x $125 x 52

$71,500

$71,500

given

60,000

60,000

Expenses
Salaries

Review Problem 4
Annual Net
Income

Annual
Cash Flow

11 x $125 x 52

$71,500

$71,500

Salaries

given

60,000

60,000

Food and supplies

given

6,000

6,000

Fee revenues
Expenses

Review Problem 4
Annual Net
Income

Annual
Cash Flow

11 x $125 x 52

$71,500

$71,500

Salaries

given

60,000

60,000

Food and supplies

given

6,000

6,000

($20,000/5)

4,000

Fee revenues
Expenses

Depreciation

Remember, depreciation is not a


cash expense.

Review Problem 4
Annual Net
Income

Annual
Cash Flow

11 x $125 x 52

$71,500

$71,500

Salaries

given

60,000

60,000

Food and supplies

given

6,000

6,000

($20,000/5)

4,000

70,000

66,000

Fee revenues
Expenses

Depreciation
Total expenses

Review Problem 4
Annual Net
Income

Annual
Cash Flow

11 x $125 x 52

$71,500

$71,500

Salaries

given

60,000

60,000

Food and supplies

given

6,000

6,000

($20,000/5)

4,000

70,000

66,000

Fee revenues
Expenses

Depreciation
Total expenses
Net Income

$1,500

Review Problem 4
Annual Net
Income

Annual
Cash Flow

11 x $125 x 52

$71,500

$71,500

Salaries

given

60,000

60,000

Food and supplies

given

6,000

6,000

($20,000/5)

4,000

70,000

66,000

Fee revenues
Expenses

Depreciation
Total expenses
Net Income
Cash flows

$1,500
$5,500

Review Problem 4

Cash payback period:


Formula: Investment/cash flow
$20,000/($1,500 + $4,000) = 3.64
years
We need to add depreciation
back to income to get cash flow

Calculation of Payback Period

Review Problem 4

Now lets calculate the annual rate of


return.
Remember, the formula is:
Net income/Average Annual Investment

Average annual investment is:


($20,000 + 0)/2 = $10,000
Annual rate of return is therefore:
$1,500/$15,000 = 10%

Review Problem 4

Now we are asked for the present value


of net annual cash flows, assuming a 10%
discount rate.
Using tables the present value of future
cash flows are: ($5,500 x 3.79097) =
$20,849
The capital investment is $20,000

Review Problem 4
Remember, the Net Present Value is
calculated by netting the present value of
the capital investments with the present
value of the future cash in-flows.
So NPV = $20,849 - $20,000 = $849
Note: The PV is positive, so we made over
10%--our minimum required rate of
return.

Review Problem 4

Now lets calculate the actual internal


rate of return.
IRR = 11.65%, better than the 10% we
hoped for!

Other Interesting Computations with


Financial Calculators

Here are some calculations on financial


decisions people make during their lives.
The purpose is not to tell you there is
one way to approach a problem, only to
show you there is approach for reaching
an answer.
All examples are based on assumptions
that may different in your situation.

Other Interesting Computations with


Financial Calculators

The backup for the calculations are on


the website in an Excel Format entitled
Financial Planning with Time Value of
Money.

Mortgages

Almost everyone during their life has


one or more home mortgages.
Understanding how mortgages work,
and the impact of time and compounding
of interest on the amount you
eventually pay for a home using a
mortgage can save tens of thousands of
dollars.

First a Little Theory

A mortgage payment is a form of


annuity
Equal payments
Equally spaced

Payment payoff periods vary


considerable (typically from 15 to 30
years).

Mortgage Calculation

Lets assume a small mortgage of


$100,000 at 12% annually, for thirty
years or 360 months (payments are
made monthly).
The rate will be the monthly rate since
payments are made monthly (12%/12 =
1%).
The number of periods will be 360.

Lets Calculate a Mortgage using Excel

Select Formulas
Select Financial
Select PMT (for payment)

Pop-up Window
The PV (present value) is
$100,000, the amount of the
mortgage.
The FV (future value) is
zero since the mortgage will
be paid off at the end of 360
periods.

The monthly payment is $1,028.61.

If payments are made at the


beginning of the month the
type is 1, if they are made
at the end of the period the
type is 0. Most mortgages
are of type 0.

It is important to remember that interest


is paid first, then principal.
Knowing this, lets figure out how much is applied to the loan the first month.
Since we owe $100,000 and the interest rate is 12% or 1% per month, the
interest
paid 1% x $100,000 or $1,000 as shown below.
Monthly Payment

$1,028.61

Less interest
Amount applied to principal.

1,000.00
$28.61

Great! We have paid $1,028.61 but only reduced our


loan by $28.61.
Dont worry. Things get better, next month it is $28.90.
The first year amortization schedule for this loan is shown
on the following page.
Happy Banker

Amortization Table
Payments in First 12 Months

Beginning Paymen Principa


Ending
Interest
Balance
t
l
Balance
$1,028.6
$1,000.0 $99,971.3
2007 Jan
$100,000.00
$28.61
1
0
9
$1,028.6
$99,942.4

Feb
$99,971.39
$28.90 $999.71
1
9
$1,028.6
$99,913.3

Mar
$99,942.49
$29.19 $999.42
1
0
$1,028.6
$99,883.8

Apr
$99,913.30
$29.48 $999.13
1
2
$1,028.6
$99,854.0

May
$99,883.82
$29.77 $998.84
1
5
$1,028.6
$99,823.9

Jun
$99,854.05
$30.07 $998.54
1
8
$1,028.6
$99,793.6

Jul
$99,823.98
$30.37 $998.24
1
1
What if when we pay the first payment
of $1,028.61, we enclose an $99,762.9
additional amount
$1,028.6
for Aug
$99,793.61
$30.67
$997.94
$28.90? Will jump from Januarys payment
additional
1 to Marchs payment. For and 4
$28.90 we will never make that $1,028.61
payment.
$1,028.6
$99,731.9

Sep
$99,762.94
$30.98 $997.63
1
6
$1,028.6
$99,700.6
a bad investment! $99,731.96
Pay $28.90, save
$1,028.61!
NotOct
$31.29 $997.32
1
7
$1,028.6
$99,669.0

Nov
$99,700.67
$31.60 $997.01
1
7
Year Month

Amortization Table
Payments in First 12 Months

Beginning Paymen Principa


Ending
Interest
Balance
t
l
Balance
$1,028.6
$1,000.0 $99,971.3
2007 Jan
$100,000.00
$28.61
1
0
9
$1,028.6
$99,942.4

Feb
$99,971.39
$28.90 $999.71
1
9
$1,028.6
$99,913.3

Mar
$99,942.49
$29.19 $999.42
1
0
$1,028.6
$99,883.8

Apr
$99,913.30
$29.48 $999.13
1
2
$1,028.6
$99,854.0

May
$99,883.82
$29.77 $998.84
1
5
$1,028.6
$99,823.9

Jun
$99,854.05
$30.07 $998.54
1
8
$1,028.6
$99,793.6

Jul
$99,823.98
$30.37 $998.24
1
1
What if we pay the sum of the remaining
principal payments for the$99,762.9
year (red)? This
$1,028.6
totals
Aug
$99,793.61
$30.67
$997.94
to $334.24. Just include that with the
1 first check of $1,028.61 and you
4 will skip so
that next month instead of making the
February payment, you will now
be on the January
$1,028.6
$99,731.9
2008
Sep
$99,762.94
$30.98
$997.63
payment, a savings of $10,980.47 in interest.
1
6
$1,028.6
$99,700.6

Oct
$99,731.96
$31.29 $997.32
1
7
$1,028.6
$99,669.0

Nov
$99,700.67
$31.60 $997.01
1
7
Year Month

Lets look at how little difference in


monthly payments a change in the length
of the mortgage makes.
Number of Years

Number of Months

Payment

Total Paid

15

180

$1,200.17

$219,090.60

20

240

$1,101.09

$264,261.60

30

360

$1,028.61

$370,299.60

40

480

$1,008.50

$484,080.00

50

600

$1,002.56

$601,536.00

100

1,200

$1,000.01

$$1,200,012.00

The difference in the monthly payment from cutting your length of mortgage in half is only
$171.56.
However, the difference in the amount you wind up paying for the house is $151,209!

Lets look at how little difference in


monthly payments a change in the length
of the mortgage makes.
Number of Years

Number of Months

Payment

Total Paid

15

180

$1,200.17

$219,090.60

20

240

$1,101.09

$264,261.60

30

360

$1,028.61

$370,299.60

40

480

$1,008.50

$484,080.00

50

600

$1,002.56

$601,536.00

100

1,200

$1,000.01

$$1,200,012.00

I have actually hear (on a radio interview) bankers complaining about how hard it is for
young people to make mortgage payments with higher interest rates (I have seen 17%
In my lifetime) and advocate going to 40 or 50 year mortgages.
Who do you think that proposal is designed to benefit. The poor young couples or the
bankers?

Objective

Remember the purpose of this exercise


is not to tell you what to do, only to
show you how, through the use of Excel,
you can determine the actual impact of
different decision options.

Lets Have Some Fun . . .

Assume there are two twin brothers,


Fred and Frank.

They have the income, the same taste in


houses.

Dream Home

They both have plans for the same


dream home, a rambler costing
$250,000.
To simplify calculations assume no down
payment
Interest rate of 8%
No inflation

Freds Decision

Fred has to have it NOW.


He borrows the money and incurs an
$1,834.41 monthly payment for 30
years.

Franks Decision
Frank is a little more patient.
He has the same payment to make on a
house.
He takes his computer and determines
how much house he can buy with a 10 year
mortgage for
$1,834.41.
He an buy a modes
$151,195 home.

Jump Ahead 10 years

Franks home is paid for. He has


$151,195 in equity.
Fred, having made the same number of
payments in the same amount still owes
$219,312. He has $250,000 - $219,312
= $30,688 in equity.

Jump Ahead 10 years

Frank takes his $151,195 equity and


makes a down payment on the $250,000
home.
His mortgage is for $98,805.
He continues making the $1,834.41
payment each month.

We are now 187 months out

It takes 67 months (5 years 7 months


for Frank to retire mortgage).
He owns the home outright.
Fred still owes $187,993. He still has
173 payments to make.

Investment

Since Frank no longer has to make a


mortgage payment, he invests the
amount he would pay each month the
stock market.
The historical return on the stock market
is 10% a year.

30 Years After Their Initial Purchase

Fred finally finishes paying for his 30


year home.
At that time he has a $250,000 home.

Frank also has the same home, but in


addition he has a savings account worth
$710,850. His net worth is $960,851.
Both have made the same payments for
the same amount of years!

Another Illustration

Young couples often say they dont have


a lot of money to save for retirement.
That may be true, but what they do
have is a lot of time, and the earlier you
start the better.
The following illustration was taken
from an insurance company brochure.

Rob and Rich

Fred and Frank have twin cousins, Rob


and Rich.
Both are concerned about retirement.

Rob and Rich

At age 25, Rob makes five yearly


deposits a mutual fund earning 12%.
He never makes another deposit.

Rob and Rich

Rich during those six years deposits


nothing.
He spends his money on wine, women,
and song.
The rest of it he plain wastes.

Rob and Rich


It takes Rich almost 25 years to catch
his brother.
When they both retire at age 65:
Rob who made six $2,000 deposits has
$856,957.79 in his savings account.
Rob who has made thirty-four $2,000
deposits has $861,326.99 in his account.

How important is time when you are


compounding interest?

New Question
How much do you have to deposit monthly at
10% to have $1,000,000 when you retire?
Age 25--$158.12
Age 30--$161.69
Age 35--$446.07
Age 40757.49
Age 50--$2,417.23
Age 55--$4,887.39

Last Example

You decide you want to surprise your


great-grand daughter with a
$1,000,000 inheritance 100 years from
now.
How much do you have to deposit today,
assuming you can get 10% a year,
compounded monthly, to reach that
goal?
Answer: $47.32

Homework

Exercise 12-2
Jacks Custom Manufacturing Company is
considering three new projects, each requiring
an equipment investment of $21,000.
Each project will last for 3 years and produce
the net annual cash flows shown below:
Year

AA

BB

CC

$7,000

$9,500

$13,000

9,000

9,500

10,000

15,000

9,500

11,000

Total

$31,000

$28,500

$34,000

Exercise 12-2

The equipments salvage value is zero.


Jack uses straight-line depreciation.
Jack will not accept any project with a
cash payback period over 2 years.
Jacks required rate of return is 12%.
Compute each projects payback period,
indicating the most desirable and least
desirable project using this method.

Exercise 12-2
Lets do project AA first:
The first years cash flow is $7,000 as shown on
the chart.
The second years cash flow is $9,000 which
brings the cumulative cash flow to $16,000.
At the end of the third year we only need
$5,000 to reach payback.
It takes $5,000/$15,000 = .33 of a year to get
this cash.
The payback period, therefore, is 2.33 years

Exercise 12-2

Using the same methodology we get


2.21 years for project BB, and 1.8 years
for project CC.
The most desirable project is CC
because it has the shortest payback
period.
The least desirable is AA because it
has the longest payback period.

Exercise 12-2

Compute the net present value of each


project. Does your evaluation change?
Data Given
Year
AA
BB
$
$
1 7,000.00 9,500.00
2 9,000.00

CC
$
13,000.00

9,500.00

10,000.00

3 15,000.00 9,500.00

11,000.00

31,000.00 28,500.00 34,000.00

Pres values of cash flows years 13

$24,101.4 $22,817.4 $27,408.6


5
0
6

Present value of
investments
Net present values of investments

(21,000.0 (21,000.0 (21,000.00


0)
0)
)
$3,101.45 $1,817.40 $6,408.66

Best option

Exercise 12-6
Mane Event is considering a new hair salon in
Pompador, California.
The cost of building a new salon is $300,000.
The new salon will normally generate annual
revenues of $70,000 with annual expenses
(excluding depreciation) of $40,000.
At the end of 15 years, the salon will have a
salvage value of $75,000.

Exercise 12-6
Okay, since depreciation is included in the
expenses, we can expenses as given from
revenues to get accounting income.
Remember, we need accounting income for
annual rate of return, not cash flows as with
NPV.
Annual income is $70,000 - $40,000 = $30,000.
The average investment is calculated using the
following formula:
(Investment + Salvage Value)/2

Exercise 12-6

So the average investment is:


($300,000 + $75,000)/2 = $187,50

So annual rate of return is:


Income $30,000/Avg. Investment
$187,500 = 16%

The End

What other problems can you come up


with to work using Excel?