Capital Budgeting Decisions

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Capital Budgeting Decisions - PowerPoint PPT Presentation

14. Chapter. Capital Budgeting Decisions. UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee. Time Value of Money.

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14

Chapter

Capital Budgeting Decisions

UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

Time Value of Money

UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

Future Value

Today . . .

Future . . .

Add interest at interest rate “i” for “n” periods.

Simple Interest

Interest Rate

P x R x T

Principal

Time

Simple Interest
• Suppose you invest \$100 at an interest rate of 10%. At the end of one year you would have \$110.

\$100 + (\$100 x .10 x 1) = \$110

P x R x T

Present Value

The Concept of Present Value

Today . . .

Future . . .

Deduct interest at interest rate “i” for “n” periods.

Reverse Compounding

The Formulas

Future Value

Present Value

Using the PV Formula
• What is the present value of \$1,000 received five years from now if your required rate of return is 12%.

Compounding Illustrated

Future Value \$567.43 for 5 years @ 12% compounded annually

1

2

3

4

5

567.43

x 1.12

------------

\$635.52

\$635.52

x 1.12

------------

\$711.78

\$711.78

x 1.12

------------

\$797.19

\$797.19

x 1.12

------------

\$893.65

\$893.65

x 1.12

------------

\$1000.88

Compounding Illustrated

Add interest for “5” periods at 12%.

Reverse Compounding Illustrated

Present Value \$1,000 for 5 years @ 12% compounded annually

1

2

3

4

5

\$635.53

------------

1.12

\$567.44

\$711.79

------------

1.12

\$635.53

\$797.20

------------

1.12

\$711.79

\$892.86

------------

1.12

\$797.20

\$1,000.00

------------

1.12

\$892.86

Reverse Compounding Illustrated

Deduct interest for “5” periods at 12%.

Practice Exercise 1

Using Present Value Tables

1

2

3

4

5

Years

Practice Exercise 1
• What is the present value of \$100 received at the end of five years if the required return is 10%?

?

\$100

Exhibit 14C-3 Present Value of \$1

Practice Exercise 2

Using Present Value Tables

1

2

3

4

5

Years

Practice Exercise 2
• What is the present value of \$100 per year for five years if the required return is 10%?

?

?

\$100

\$100

\$100

\$100

\$100

\$100

Exhibit 14C-4 Present Value of an Annuity of \$1 in Arrears

Practice Exercise 3

Using Present Value Tables

Practice Exercise 3
• Examine the table “Present Value of \$1”
• Explain why the numbers decrease as you move from left to right in a given row.

The numbers decrease from left to right in a given row because cash received in the future is worth less the higher your required rate of return.

Remember the formula:

Practice Exercise 4
• Examine the table “Present Value of \$1”
• Explain why the numbers decrease as you move from left to right in a given row.
• Explain why the numbers decrease as you move from top to bottom in a given column.

The numbers decrease from top to bottom in a given column because cash received further in the future is less valuable today.

Remember the formula:

Practice Exercise 5

Calculate Present Value

Practice Exercise 5
• Suppose you face the prospect of receiving \$200 per year for the next 5 years plus an extra \$500 payment at the end of 5 years.
• Determine how much this prospect is worth today if the required rate of return is 10%.

Annuity

Lump Sum

PV of Annuity

of \$1 - Table 14C-4

N=5, i=10

PV of \$1 - Table 14C-3

N=5, i=10

Practice Exercise 6

Calculate Present Value

Practice Exercise 6
• Juanita Martinez is ready to retire and has a choice of three pension plans.
• Plan A provides for an immediate cash payment of \$100,000
• Plan B provides for the payment of \$10,000 per year for 10 years and \$100,000 at the end of year 10.
• Plan C will pay \$20,000 per year for 8 years.

8% Required Rate of Return

Plan A:
• Plan B:
• Plan C: