PRESENT VALUE AND CAPITAL BUDGETING

Present Value and Capital Budgeting

Module 2 - Case

Present Value and Capital Budgeting

Part I - Present Value

A. Solution

Bank account = $ 15,000

Time in years = 1 year

Interest rate (discount rate) = 7 % Present value =?

Discount Rate =

7.00 %

Year

Cash Flow

PV Factor

Present Value

1

15,000

0.934579439

14,019

PV =

$ 14,019

Bank account = $15,000.00

Time in years = 1 year

Interest rate (discount rate) = 4% Present value =?

Discount Rate =

4.00 %

Year

Cash Flow

PV Factor

Present Value

1

15,000

0.961538462

14,423

PV =

$ 14,423

B. Solution

Bank Account A = $ 6500

Bank Account B = $ 12600

Time in years = 1 year

Interest Rate = 6 %

Present value =?

Bank Account A

Discount Rate =

6.00 %

Year

Cash Flow

PV Factor

Present Value

1

6,500

0.943396226

6,132

PV =

$ 6,132

Bank Account B

Discount Rate =

6.00 %

Year

Cash Flow

PV Factor

Present Value

1

12,600

0.943396226

11,887

PV =

$ 1,887

C.

Projected Income in next 3 years:

Year 1: $ 49,000,000Year 2: $ 61,000,000Year 3: $ 85,000,000

Time in Years= 3 years

Present Value = 7 %

Discount rate = 7%

Discount Rate =

7.00 %

Year

Cash Flow

PV Factor

Present Value

1

49,000,000

0.934579439

45,794,393

2

61,000,000

0.934579439

57,009,346

3

55,000,000

0.934579439

51,401,869

Present Value

$ 54,205,607

Discount Rate =

5.00 %

Year

Cash Flow

PV Factor

Present Value

1

42,000,000

0.952380952

40,000,000

2

62,000,000

0.952380952

59,047,619

3

99,000,000

0.952380952

94,285,714

Present Value

$ 93,333,333

Discount Rate =

3.00 %

Year

Cash Flow

PV Factor

Present Value

1

42,000,000

0.970873786

40,776,699

2

62,000,000

0.970873786

60,194,175

3

99,000,000

0.970873786

96,116,505

Present Value

$ 97,087,379

The calculation shows that the higher the discount rate of future income inflows, the lower the present value. The Present value at discount rate 7 % gives the present value $ 154,205,607, which is lowest in the above three situation while the present value at discount rate 3% is $ 197,087,379, which is the highest. The discount factor or interest rate at which the present value of money is factorized to calculate the future earnings.

Part II - Capital Budgeting

A

year cash flow

0%

 

2%

 

6%

 

11%

 

-400000

1

-400000

1

-400000

1

-400000

1

-400000

100000

1

100000

0.98039

98039.2

0.9434

94339.6

0.9009

90090.1

120000

1

120000

0.96117

115340

0.89

106800

0.81162

97394.7

850000

1

850000

0.94232

800974

0.83962

713676

0.73119

621513

NPV

 

670000

 

614353

 

514816

 

408997

MIRR

 

38.82%

 

39.09%

 

39.66%

 

40.37%

The graph is plotted with discount factor at x-axis and the net present value at y-axis. It clearly shows the value of net present at specific discount rate. This proves graphically that as discount rate increases, the net present value decreases.

B

year cash flow

1%

 

4%

10%

 

18%

 

-815000

1

-815000

1

-815000

1

-815000

1

-815000

141000

0.9901

139604

0.96154

135577

0.90909

128182

0.84746

119492

320000

0.9803

313695

0.92456

295858

0.82645

264463

0.71818

229819

440000

0.97059

427060

0.889

391158

0.75131

330579

0.60863

267798

NPV

 

65358.4

 

7593.31

 

-91777

 

-197892

IRR

 

4.42%

This graph also indicates the decrease in present value as the discount rate increase. In this situation, the difference in the discount rate is so high, which decreases the net present value to negative value.

C.

Initial investment = 4.2 million

Profitability Index = 0.94

PV of outflow =

-4.2

PV of inflow =

3.948

Net Present Value=

-0.252

Profitability index (PI) is a relative measure of the level of income per unit cost is calculated as the present value of future cash flows to the initial cost of the project:

The Time Value of Money

The notion that money has a time value is one of the basic concepts of finance. In a world of complete certainty, the interest rate is the rate of exchange between the values of money at two points in ...