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Prepared by Diane Tanner University of North Florida

Chapter 14. Net Present Value and Internal Rate of Return. Prepared by Diane Tanner University of North Florida. Acquisition of long-term assets require more than one-year to recover the cost The value of money over time is often considered a factor i.e., time value of money

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Prepared by Diane Tanner University of North Florida

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  1. Chapter 14 Net Present Value and Internal Rate of Return Prepared by Diane Tanner University of North Florida

  2. Acquisition of long-term assets require more than one-year to recover the cost The value of money over time is often considered a factor i.e., time value of money Money is worth more today than tomorrow Present value concepts determine the value of money to be received in the future at today’s dollars Tools to Evaluate Investment Opportunities 2

  3. Present Value Concept 3 • Goal is to determine the value of money to be received in the future at today’s dollars • Calculating present value • Removes the interest cost from cash to be received in the future • Example: You want to accumulate $500 in at the end of one year in a bank account that pays 4% interest P + [P x 4% x 1 year ] = 500   Present value = $480.77 The interest cost is the difference in the future value of $500 and the present value of $480.77. or $19.23

  4. Net Income or Cash Flows? 4 • Present value is based on the cost of interest of money over time • Money (cash) can be invested • Net income (profit) cannot be invested • Cash flows involved with capital budgeting • Operating activities • Investing activities

  5. Capital Budgeting Assumptions 5 • Operating cash inflowsoccur in the same period as reported as revenues on the income statement • Operating cash outflowsoccur in the same period as reported as expenses on the income statement • Operating cash flows occur at the end of the year • Conservatism

  6. Cash Flow Time Lines 6 • Used to identify the point in time in which the cash flows occur • Operating cash flows • Occur every year as net inflows • Inflation and other budgeting issues may cause differences in amounts each year • Investing cash flows • Occur at time 0 as an outflow when the asset is to be purchased • Occur at the end of the useful life as an inflow from sale of asset for its salvage value

  7. Step 1 Identify all cash flows of a potential investment Draw a time line and label inflows and outflows Step 2 Discount the cash flows to their present values Use required rate of return (hurdle rate) Step 3 Determine the NPV Combine (add/subtract) the PV of cash inflows with the PV of the outflows Step 4 If positive or zero, accept. If negative, reject. Net Present Value Method (NPV) 7

  8. If the NPV is zero The investment will earn a return equal to the required rate of return. If the NPV is positive The investment will earn a return greater than the required rate of return. If the NPV is negative The investment will earn a return less than the required rate of return. Interpret NPV 8 Accept Accept Reject

  9. An alternative to the NPV method The rate of return that equates the present value of future cash flows to the investment outlay The rate that generates a zero NPV Useful When comparing two or more investments When comparing to the company’s required rate of return Internal Rate of Return (IRR) 9

  10. Internal Rate of Return (IRR) 10 Step 1 Identify the cash flows of a potential investment • Inflows and outflows Step 2 Discount the cash flows to the present value using the BAII Step 3 If the IRR is greater to or equal to the RRR, accept. If IRR is less than RRR, reject.

  11. If the IRR is equal to the RRR The investment will earn a return equal to the required rate of return. If the IRR is greater than the RRR The investment will earn a return greater than the required rate of return. If the IRR is less than the RRR The investment will earn a return less than the required rate of return. Interpret IRR 11 Accept Accept Reject

  12. Using Cash Flow Time Lines 12 • Label time periods as 0, 1, 2, 3 etc. stopping at the end of the useful life of the proposed acquisition • Post operating activity amounts on the time line based on when the cash flow is expected to occur, beginning with year 1 • Post the investing cash flow for the acquisition cost at time 0 • Show as negative amount since an outflow • If the investment has a salvage value • Post as an investing cash flow at end of useful life • Show as positive amount since an inflow

  13. Using Cash Flow Time Lines 13 0 1 2 3 4 Example: Purchased a $5,000 turkey smoker with an estimated salvage value of $500 and a 4 year estimated life. Operating cash flows are expected to be $2,200 per year. 2700 (5000) 2200 2200 2200 Operating $2,200 + Investing $500

  14. The End

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