In your initial post, compare the information pertaining to Master Budgets (chap
ID: 2430488 • Letter: I
Question
In your initial post, compare the information pertaining to Master Budgets (chapter 9) to your personal budget (you do not need to provide actual number!) If you were to use your personal budget as business managers use the Master Budget, you would probably find some areas where you could save money, or make a change so that you will have more money in the future.
Provide an example of investing in something that will hopefully realize future profits (incorporating alternative energy sources as you build your new home; buying a hybrid vehicle for your next car; switching to a “whole food” diet rather than buying pre-packaged foods). Give enough information in your example so that your peers can address the following questions in their replies.
How did the example illustrate the time value of money concept?
How was the Net Present Value concept illustrated?
How was the payback period determined?
Explanation / Answer
The Time Value of Money
Donna was puzzled about something, so she went to talk to Becky about it. She told her friend that the problem is whether she would want a dollar today or a dollar one year from now. She doesn't see what the difference is, since it's still one dollar, no matter when you get it. Becky had to think about this for a while. When she sees Donna again, she tells her to take that dollar now and put it in a savings account. The bank will pay interest, so one year from now she'll have more than one dollar. To sum up the time value of money, money that you have right now will be worth more over time. So one dollar now will be worth more than a dollar in a year from now.
Future Value
Donna went home and did some research and she discovered a formula for future value, or how much money put in the bank today will turn into at some point in the future with the interest. She needs to know three things:
Then she can use a formula to figure out how much she'll have at the end. The formula is:
FV = PV (1 + r)^n
In this formula, PV equals how much she has now, or the present value, r equals the interest rate she will earn on the money, n equals the number of years she will put the money away for, and FV equals how much she will have at the end or future value.
Let's imagine that Donna puts $100 in the bank for five years at five percent interest, and plug that into the equation.
FV = 100 (1 + .05)^5
FV = 100 * 1.2762
FV = $127.62
Present Value
Donna's parents think she's a pretty smart girl, especially after she shows her Dad these cool formulas. Dad knows he will need money in a few years to pay for Donna's college. He's wondering how much he can invest today in some CDs that would be worth $20,000 or so in 10 years when he'll need it. Donna shows him a formula for present value, or how much you need to save today to have a specific amount at some point in the future. Here's the formula:
PV = FV / (1 +r)^n
In this formula, PV equals how much he needs to have today, or present value; r equals the interest rate he'll earn; n equals the number of years before he needs the money; and FV equals how much he will need in the future, or future value. So, if Dad needs the $20,000 in 10 years and can invest what he has for five percent, let's find out how much he needs to invest today.
PV = $20,000 / (1.05)^10
PV = $20,000 / 1.6289
PV = $12,278
Net present value (NPV) is the present value of an investment's expected cash inflows minus the costs of acquiring the investment.
HOW IT WORKS (EXAMPLE):
The formula for NPV is:
NPV = (Cash inflows from investment) – (cash outflows or costs of investment)
Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at Company ABC's projections for the next 10 years. It discounts those projected cash inflows back to the present using its weighted average cost of capital (WACC) and then subtracts the cost of purchasing Company ABC.
[To learn how to calculate present value (PV), be sure to read A Primer on Present Value and Its Many Uses]
Cost to purchase Company ABC today: $1,000,000
Present value (PV) of cash flows from acquiring Company ABC:
Year 1: $200,000
Year 2: $150,000
Year 3: $100,000
Year 4: $75,000
Year 5: $70,000
Year 6: $55,000
Year 7: $50,000
Year 8: $45,000
Year 9: $30,000
Year 10: $10,000
Total: $785,000
Now that we know the total cash flow for the next 10 years (the total cash inflows from the investment), along with total cost of the investment in Company ABC, we can use the formula to calculate NPV:
Net Present Value (NPV) = $785,000 - $1,000,000 = -$215,000
At this point, management for Company XYZ would use the net present value rule to decide whether or not to pursue the acquisition of Company ABC. Because the NPV is negative, they should say, "No."
WHY IT MATTERS:
NPV is used to analyze an investment decision and give company management a clear way to tell if the investment will add value to the company. Typically, if an investment has a positive net present value, it will add value to the company and benefit company shareholders.
Net present value calculations can be used for either acquisition (as shown in the example above) or future capital projects. For example, if a company decides to open a new product line, they can use NPV to find out if the projected future cash inflows cover the future costs of starting and running the project. If the project has a positive NPV, it adds value to the company and therefore should be considered.
Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Formula
The formula to calculate the payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate the payback period is:
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period:
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring the initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring the initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
? 3 + 0.58
? 3.58 years
Advantages and Disadvantages
Advantages of payback period are:
Disadvantages of payback period are:
Payback Period = Initial Investment Cash Inflow per Period