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Chapter 3
Capital Budgeting (Focusing on Cash Flows)

Time Value of Money
 •A dollar today is worth more than a dollar tomorrow
 •Opportunity cost related to having cash at different points in time
 •Basic computations to reflect this
 –Single period flow (see table on page 131)
 –Annuity (see table on page 132)

When determining Time Value of Money need to answer these two questions:
 1) What is the interest rate we are assuming?
 2) How far into the future?

Single period flow computation for TVM
Present value of $1 received at the end of period n at an interest rate of i%

Annuity for TVM
We have uniform flows of money

Figures Are Cash Flows
 •You can spend cash
 •You cannot spend income
 •You can earn interest on cash
 •You cannot earn interest on income

When Do Flows Occur?
 •Present value computations assume flows occur at end of period
 •Compounding occurs at end of period
 •In most problems we will assume that the period is a
 year long

Complexities with Present Value
  Taxes and depreciation tax shield
  Inflation
  If flows occur during the year
  Risk
  Discount Rates

Taxes and Depreciation Tax Shields
 –Reflects tax savings from being able to subtract
 depreciation in determining income tax.
  You have to allocate these savings over timenot all at once
  These are cash inflows

Capital Gains =
 = Present Market value  book value
 = sales price  book value
 * When replacing an old product, multiply by tax rate and subtract during year 0

Revenue =
Price per unit x units sold

depreciation =
(Original cost  salvage value) / useful life

Cash flow analysis for year zero
((negative)cost of new machine) + present market value of old machine  (capital gain x tax rate)

Cash flow analysis for years 14
 Rev  VC  Maintenance  property tax = BTNI
 BTNI x (1TR) = ATNI
 ATNI + (depreciation x TR) = Cash flow/years 13
For year 4, add salvage value

NPV comparison final answer
Multiply each year's CF times given interest rate in table. Add all values together

Payback
Add each year's cash inflows to cost. At the end of year 3, you still need 14,500 dollars to pay it off so you divide that amount by year 4's cash inflow and add that fraction value to 3 years to determine total payback time.

NPV decisions
If the value is positive, you should do the project. If it is negative, don't do it because you are losing money on cost of capital. If cost of capital is 10%, and NPV is positive, your cost of capital ends up being less than 10%.

