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Capital Budgeting

and Other Time

Value of Money

Applications

Richard E. McDermott, Ph.D.

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.

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.

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:

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

26,000

22,000

Income tax expense

Net income

180,000

20,000

7,000

$ 13,000

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

Net income

Add: Depreciation expense

$13,000

26,000

Net income

Add: Depreciation expense

Cash flow

$13,000

26,000

$39,000

The cash payback period in this example is therefore

3.33 years, computed as follows:

$130,000

$39,000

3.33 years

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.

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

$300

$200

$100

Time

A Little Theory . . .

We let it grow for three

years.

Money

$100 x 1.10 = $110

$133.10

$130

$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

periods at 10% is $133.10.

The present value of $133.10 for three

periods is $100.

$120

$100

present value of a lump sum.

0

Time

Lump Sum

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

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)

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

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!

yearly instead of monthly, does it make

a difference?

Lets see.

This time lets use the menu approach

to solving the Excel problem.

Calculation

then financial just as we did before.

This time

select PV from

the drop down

menu.

Hit OK. The amount you

must deposit today is

$72.57..

Compunding monthly

instead of yearly obviously

makes a difference.

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

$331 from the annuity.

$300

$100 at 10% interest per period is $331

$200

$100

using Excel.

0

Time

Problem

Select Formulas

Select Financial

However we are going to fill the

pop up box in differently. Now

we will insert $100 in the Pmt

box.

chart!

each, at the end of three years you will have

$331.00 in savings.

Practice Problem

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

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

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.

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?

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.

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?

before.

Select FV to get the following box.

The answer is . . .

$70,339.57

Equal

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?

Equal

Why do we care?

Because this is one way of valuing a

business!

Why We Care

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

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).

Today

Valuing a Business

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

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 . . .)

Excel Sheet

from operations plus the $10,000 salvage value

of the equipment when the Laundry is sold.

The answer is $184,238.35.

menu at the top of

the page,

Formulas, and then

Financial, as we

have done before.

Then select from

the drop down box

NPV.

Note

that all

of the

values

are not

shown

on this

copy of

the popup box.

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.

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.

Cash Flows That Looks Like This

Before . . .

Then Select Financial

Select IRR

Drag and drop the cash flows from the Excel Spreadsheet into the

values box.

what the IRR will be

10.15%

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.

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

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

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(.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

It means that the hospital will earn

$100,050.32 in addition to a 14% return

on the $2,000,000.

Solution

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%!

the discounted cash flow techniquea technique

based on the time value of money.

S

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

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

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

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

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

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.

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.

The annual rate of return technique is based on

accounting data. It indicates the profitability

of a capital expenditure. The formula is:

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.

Average Investment

Expected annual net income ($13,000) is obtained from

the projected income statement. Average investment is

derived from the following formula:

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

The expected annual rate of return for Reno Companys

investment in new equipment is therefore 20%, computed

as follows:

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

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

($55,000).

If it were not, one would add annual

depreciation to net income to calculate it.

$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

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

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

project. Does your evaluation change?

Review Problem 2

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

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

Income $30,000/Avg. Investment

$187,500 = 16%

Review Problem 4

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

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

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

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

items are expected to total $6,000

annually.

Review Problem 4

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

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

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

given

6,000

6,000

($20,000/5)

4,000

Fee revenues

Expenses

Depreciation

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

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

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

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

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

Review Problem 4

return.

Remember, the formula is:

Net income/Average Annual Investment

($20,000 + 0)/2 = $10,000

Annual rate of return is therefore:

$1,500/$15,000 = 10%

Review Problem 4

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

rate of return.

IRR = 11.65%, better than the 10% we

hoped for!

Financial Calculators

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.

Financial Calculators

the website in an Excel Format entitled

Financial Planning with Time Value of

Money.

Mortgages

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.

annuity

Equal payments

Equally spaced

considerable (typically from 15 to 30

years).

Mortgage Calculation

$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.

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.

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.

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

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

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

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

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!

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

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.

Fred and Frank.

houses.

Dream Home

dream home, a rambler costing

$250,000.

To simplify calculations assume no down

payment

Interest rate of 8%

No inflation

Freds Decision

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.

$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.

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.

for Frank to retire mortgage).

He owns the home outright.

Fred still owes $187,993. He still has

173 payments to make.

Investment

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.

year home.

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

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

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.

and Rich.

Both are concerned about retirement.

deposits a mutual fund earning 12%.

He never makes another deposit.

nothing.

He spends his money on wine, women,

and song.

The rest of it he plain wastes.

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.

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

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

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

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

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

5

0

6

Present value of

investments

Net present values of investments

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

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

Income $30,000/Avg. Investment

$187,500 = 16%

The End

with to work using Excel?

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