Capital budgeting decisions (Chapter 11) should be based on cash flows that are adjusted for the time value of money. The time value of money recognizes that a dollar received or spent in the future is less valuable than a dollar received or spent in the present. Calculations such as the internal rate of return, net present value, and excess present value include adjustments for the time value of money. In these calculations present value factors, financial calculators, or computer software are used to discount the cash flows to their present values (you could also use formulas found in Excel software).

Under accrual accounting, revenues and expenses are reported based on accounting principles. This means that revenues are reported when they are earned, and expenses are matched to the periods of the revenue. In other words, revenues and expenses are not reported on the income statement when the money is received or spent. Further, the revenue and expense amounts are not adjusted for the time value of money because of the monetary unit assumption.

Popular methods of capital budgeting include net present value (NPV) (Review page 407), internal rate of return (IRR) (Review page 409), accounting rate of return (ARR) (Review page 405), and payback period (Review page 403).

The internal rate of return (IRR) and the net present value (NPV) are both discounted cash flow techniques or models. This means that each of these techniques looks at two things: 1) the current and future cash inflows and outflows (rather than the accrual accounting income amounts), and 2) the time at which the cash inflows and outflows occur. In other words, these models consider the time value of money: a dollar today is more valuable than a dollar in one year, a dollar received in three years is more valuable than a dollar received in five years, and so on.

The internal rate of return or IRR is the rate that will discount all cash inflows and outflows to a net present value of $0. In other words, the IRR model provides you with the true, effective interest rate being earned on a project after taking into consideration the time periods when the various cash amounts are flowing in or out. If you use present value tables to calculate the internal rate of return, it will require some trial and error or iterations to determine the exact rate the project is earning. Software or some financial calculators will provide a quicker and more accurate answer.

The net present value (NPV) discounts all of the cash inflows and outflows by a specified interest rate. The net amount of all of the discounted amounts is the net present value. If the net present value is $0, the project is expected to earn exactly the specified rate. If the net present value is a positive amount, the project will be earning more than the specified interest rate. A negative net present value means the project is expected to earn less than the specified interest rate.

NPV is the acronym for net present value. Net present value is a calculation that compares the amount invested today to the present value of the future cash receipts from the investment. In other words, the amount invested is compared to the future cash amounts after they are discounted by a specified rate of return.

For example, an investment of $500,000 today is expected to return $100,000 of cash each year for 10 years. The $500,000 being spent today is already a present value, so no discounting is necessary for this amount. However, the future cash receipts of $100,000 for 10 years need to be discounted to their present value. Let's assume that the receipts are discounted by 14% (the company's required return). This will mean that the present value of the those future receipts will be approximately $522,000. The $522,000 of present value coming in is compared to the $500,000 of present value going out. The result is a net present value of $22,000 coming in.

Investments with a positive net present value would be acceptable. Investments with a negative net present value would be unacceptable.

It is also known as investment appraisal. An approach used in capital budgeting where the present value of cash inflows is subtracted by the present value of cash outflows. NPV is used to analyze the profitability of an investment or project. It focuses on the expected cash inflows and outflows rather than net income and it is based on the theory of compound interest

There is a brief summary of the tables and formulas used to calculate included in your appendix B: Time Value of Money beginning on page B.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the value of a dollar today versus the value of that same dollar in the future, after taking inflation and return into account. Basically, once the calculations are completed and the NPV of a prospective project is positive, then it should be accepted. However, if it is negative, then the project probably should be rejected because cash flows are negative.

One of the biggest concerns for students when working with Net present value, is making the determination of which table to use: you can use the info in Appendix B to help you work through this - the bottom line is in the Appendix, Table B1 should be used in discounting single amounts while Table B3 is used for a series of equal amounts. The factors in table B2 and B4 are simply summations of factors from the Present Value (B1 & B3).

The minimum desired rate of return can have a large effect on NPV -the higher the minimum desired rate of return, the lower the present value of each future cash inflow and the lower the NPV of the project. Investments that are desirable at one rate of interest may be undesirable at a higher rate of interest. Since we are concerned with cash flows, and not revenues and expenses, depreciation is an expense that does not require a current cash outlay. Depreciation affects capital budgeting decisions by creating a tax savings in the amount of the tax rate multiplied by the depreciation claimed. Review page 399 in your text. I have included the discussion about tax savings from depreciation because in the 2nd part of your Unit 5 IP, it discusses the MACRS depreciation applied to the acquisition of the new lifts - this is the reason that I am supplying this table for your reference to calculate the TAX SAVINGS from this accelerated type of depreciation.

1)To find the present value of tax savings, you find the factor from above table for appropriate recovery period and required rate of return.

2)Multiply the factor by the tax rate to find the tax savings per dollar of investment.

3)Multiply the result by the amount of the investment to find the total tax savings.

Basically, when you approach your IP 5, address the following questions for part 1:

Number 1, what is the initial investment?

Number 2, what are the expected cash inflows?

Number 3, what are the expected cash outflows?

Number 4, what are the net inflows/outflows?

Number 5, what is the present value of net cash flows?

Finally, compare to the initial investments and make the determination of will this be a profitable investment?

Refer to page 407 "Net Present Value Decision Rule"

For Part 2:

Number 1, what is the after tax net cash flows from part 1?

Take Net Cash Flows from part 1 and deduct taxable amount to find After Tax Net Cash Flows.

Number 2, what is the present value of after tax net cash flows? PV Factor x #1

Number 3, what is the tax savings from depreciation (use special table given to you)?

Tax Savings formula = Initial Investment x Tax Rate x MACRS PV Factor

Number 4, what is the total after tax net cash flows AND tax savings?

Finally, compare initial investment to this figure to determine if this project is wise on an after-tax basis

Number 2 + Number 3 vs initial investment?

Deer Valley Lodge, a ski resort in the Wasatch Mountains of Utah, has plans to eventually add five new chairlifts. Suppose that one lift costs $2 million, and preparing the slope and installing the lift costs another $1.3 million. The lift will allow 300 additional skiers on the slopes, but there are only 40 days a year when the extra capacity will be needed. (Assume that Deer Valley Lodge will sell all 300 lift tickets on those 40 days.) Running the new lift will cost $500 a day for the entire 200 days the lodge is open. Assume that the lift tickets at Deer Valley cost $55 a day. The new lift has an economic life of 20 years.

1. Assume that the before-tax required rate of return for Deer Valley is 14%. Compute the before-tax NPV of the new lift and advise the managers of Deer Valley about whether adding the lift will be a profitable investment. Show calculations to support your answer.

2. Assume that the after-tax required rate of return for Deer Valley is 8%, the income tax rate is 40%, and the MACRS recovery period is 10 years. Compute the after-tax NPV of the new lift and advise the managers of Deer Valley about whether adding the lift will be a profitable investment. Show calculations to support your answer.

3. What subjective factors would affect the investment decision?

Attachment:- template-Classroom.xlsx