MGF 301 Lecture Notes - Lecture 3: Net Present Value, Cash Flow, Discount Window
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Question: | ||||
The Sanders Electric Company is evaluating two projects for possible inclusion in the firmâs capital budget. Project M will require a $37,000 investment while project Oâs investment will be $46,000. After-tax cash inflows are estimated as follows for the two projects: | ||||
Year | Project M | Project O | ||
1 | $12,000 | $10,000 | ||
2 | 12000 | 10000 | ||
3 | 12000 | 15000 | ||
4 | 12000 | 15000 | ||
5 | 15000 | |||
a. | Determine the payback period for each project. | |||
Payback (M) = | ||||
Payback (O) = | ||||
b. | Calculate the net present value and profitability index for each project based on a 10 percent cost of capital. Which, if either, of the project is acceptable? | |||
NPV (M) = | ||||
PI (M) = | ||||
NPV (O) = | ||||
PI (O) = | ||||
c. | Determine the internal rate of return and modified internal rate of return for Projects M and O. | |||
IRR (M): | ||||
IRR (O): | ||||
MIRR calculation of project M: | ||||
MIRR calculation of project O: |
Calculating Payback. Global Toys Inc., imposes a payback cutoff of three years for its international investment projects. If the company has the following two projects available, should it accept either of them?
Year Cash Flow (A) Cash Flow (B) 0 â$55,000 â$ 95,000 1 19,000 18,000 2 27,000 26,000 3 24,000 28,000 4 9,000 260,000 |
Which Project should be accepted A or B?
a. The payback for Project A is: Payback =
b. The payback for Project B is: Payback =
c. Which project should be accepted:
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Calculating AAR. Youâre trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $14 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,253,000, $1,935,000, $1,738,000, and $1,310,000 over these four years, what is the projectâs average accounting return (AAR)?
Calculating AAR, the average net income divided by the average book value. (Show work by calculating net income and average book value):
a. Average net income =
b. Average book value =
c. AAR =
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Calculating IRR. A firm evaluates all of its projects by applying the IRR rule. If the required return is 11 percent, should the firm accept the following project?
Year Cash Flow 0 â$153,000 1 78,000 2 67,000 3 49,000 |
Calculating IRR the interest rate that makes the NPV of the project equal to zero. (Show work by calculating IRR):
a. IRR =
b. Should the project be accepted and why?
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Calculating NPV. For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of 9 percent, should the firm accept this project? What if the required return was 21 percent?
Calculating NPV. Hint the NPV of a project is the PV of the outflows minus by the PV of the inflows. (Show work by calculating NPV):
a. @ 9% required return.
NPV@ 9% required return =
b. Should the project be accepted:
c. @ 21% required return.
NPV@ 21% required return =
d. Should the project be accepted:
INPUT DATA: | KEY OUTPUT: | |||||||
Land initial cost | $150,000 | NPV | $1,408,166 | |||||
Land opportunity cost (and salvage value) | $200,000 | IRR | 14.7% | |||||
Building/equipment cost | $10,000,000 | MIRR | 12.9% | |||||
Build/equipment salvage value | $5,000,000 | Payback | 4.0 | |||||
Procedures per day | 20 | |||||||
Average net revenue per procedure | $1,000 | |||||||
Labor costs | $696,000 | |||||||
Utilities costs | $50,000 | |||||||
Incremental overhead | $36,000 | |||||||
Supply cost ($/procedure) | $200 | |||||||
Inflation rate on charges | 3.0% | |||||||
Inflation rate on costs | 3.0% | |||||||
Tax rate | 40.0% | |||||||
Revenues lost from inpatient surgeries | $1,000,000 | |||||||
Reduction in inpatient surgery costs | $500,000 | |||||||
Cost of capital | 10.0% | |||||||
MODEL-GENERATED DATA: | ||||||||
Depreciation Schedule: | ||||||||
MACRS | Deprec. | End of Year | ||||||
Year | Factor | Expense | Book value | |||||
1 | 0.20 | $2,000,000 | $8,000,000 | |||||
2 | 0.32 | 3,200,000 | 4,800,000 | |||||
3 | 0.19 | 1,900,000 | 2,900,000 | |||||
4 | 0.12 | 1,200,000 | 1,700,000 | |||||
5 | 0.11 | 1,100,000 | 600,000 | |||||
6 | 0.06 | 600,000 | 0 | |||||
Net Cash Flows: | ||||||||
Project Cash Flows | ||||||||
0 | 1 | 2 | 3 | 4 | 5 | |||
Land opportunity cost | ($200,000) | |||||||
Building/equipment cost | (10,000,000) | |||||||
Net revenues (including inpatient loss) | $4,000,000 | $4,120,000 | $4,243,600 | $4,370,908 | $4,502,035 | |||
Less: Labor costs | 696,000 | 716,880 | 738,386 | 760,538 | 783,354 | |||
Cost savings on inpatients | (500,000) | (515,000) | (530,450) | (546,364) | (562,754) | |||
Utilities costs | 50,000 | 51,500 | 53,045 | 54,636 | 56,275 | |||
Supplies | 1,000,000 | 1,030,000 | 1,060,900 | 1,092,727 | 1,125,509 | |||
Incremental overhead | 36,000 | 37,080 | 38,192 | 39,338 | 40,518 | |||
Depreciation | 2,000,000 | 3,200,000 | 1,900,000 | 1,200,000 | 1,100,000 | |||
Income before taxes | $718,000 | ($400,460) | $983,526 | $1,770,032 | $1,959,133 | |||
Taxes | 287,200 | (160,184) | 393,410 | 708,013 | 783,653 | |||
Project net income | $430,800 | ($240,276) | $590,116 | $1,062,019 | $1,175,480 | |||
Plus: Depreciation | 2,000,000 | 3,200,000 | 1,900,000 | 1,200,000 | 1,100,000 | |||
Plus: Net land salvage value | 180,000 | |||||||
Plus: Net building/equipment salvage value | 3,240,000 | |||||||
Net cash flow | ($10,200,000) | $2,430,800 | $2,959,724 | $2,490,116 | $2,262,019 | $5,695,480 | ||
Cumulative net cash flow | ($10,200,000) | ($7,769,200) | ($4,809,476) | ($2,319,360) | ($57,341) | $5,638,139 | ||
(For payback calculation) | ||||||||
Profitability and Breakeven Measures: | ||||||||
Net present value (NPV) | $1,408,166 | |||||||
Internal rate of return (IRR) | 14.7% | |||||||
Modified IRR (MIRR) | 12.9% | |||||||
Payback | 4.0 | |||||||
(Question) |
What is âincremental cash flowâ? Because the project, at least constructively, will be financed in part by debt, should the cash flows include interest expense? Think about why or why not . . .
The hospital already owns the site for the center, so should any cost be attributed to the land? Why or why not . . .
What overhead costs should be included in the analysis?
How should the cannibalization of inpatient surgeries be handled?
What is the projectâs payback? What is the economic interpretation of payback? What type of information do decision-makers get from the payback?
What is the projectâs net present value (NPV)? Think about the economic rationale behind this profitability measure.
What is the projectâs internal rate of return (IRR)? Think about the economic rationale behind IRR. Do the NPV and IRR always lead to the same conclusion about a projectâs profitability?
What is the projectâs modified internal rate of return (MIRR)? How does MIRR differ from IRR? Which one is a better measure of a projectâs true rate of return?
To give the board a better feel for the impact of inflation on the outpatient surgery center, you may wish to construct an inflation impact table.
You may wish to conduct a sensitivity analysisâcreating a table and/or graph that shows the sensitivity of NPV to procedures per day, average charge, and salvage value. Assume that each variable can deviate from its base case value by +/-10, +/-20, and +/-30 percent. Think about the advantages and disadvantages of sensitivity analysis.
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