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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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Presentation Transcript
slide1

Chapter 14

Net Present Value and Internal Rate of Return

Prepared by

Diane Tanner

University of North Florida

tools to evaluate investment opportunities
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

present value concept
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

net income or cash flows
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
capital budgeting assumptions
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
cash flow time lines
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
net present value method npv
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

interpret npv
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

internal rate of return irr
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

internal rate of return irr1
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.

interpret irr
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

using cash flow time lines
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
using cash flow time lines1
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