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

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capital budgeting decisions

14

Chapter

Capital Budgeting Decisions

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

time value of money

Time Value of Money

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

future value
Future Value

Today . . .

Future . . .

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

simple interest
Simple Interest

Interest Rate

P x R x T

Principal

Time

simple interest5
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

the concept of present value
The Concept of Present Value

Today . . .

Future . . .

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

Reverse Compounding

the formulas
The Formulas

Future Value

Present Value

using the pv formula
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

Compounding Illustrated

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

slide17

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

Reverse Compounding Illustrated

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

slide19

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

Practice Exercise 1

Using Present Value Tables

practice exercise 121

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

Practice Exercise 2

Using Present Value Tables

practice exercise 224

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

Practice Exercise 3

Using Present Value Tables

practice exercise 327
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.
slide28

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
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.
slide30

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

Practice Exercise 5

Calculate Present Value

practice exercise 532
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

slide33

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

Practice Exercise 6

Calculate Present Value

practice exercise 635
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

slide36
Plan A:
  • Plan B:
  • Plan C: