School

University of WaterlooDepartment

Accounting & Financial ManagementCourse Code

AFM123Professor

Peter BlakeLecture

11This

**preview**shows pages 1-2. to view the full**6 pages of the document.**Monday March 23rd 2015

Capital Budgeting

-big business; buying assets, evaluating opportunities

-time value of money means must analyze based on PV of cash flows (present value)

•use tables to get factors to arrive at PV (cash flow x factor = PV)

-restate all cash flows to today

different tables - for Present Value of $1 and for Present Value of an Annuity of $1

Example 1: Business deciding whether or not to buy an additional stamping machine

(something they use in their manufacturing process)

Cost of the machine $200,000

Machine will generate additional margins $35,000 / year (of the next 8 years)

(sales - variable costs)

Machine will last 8 years but will need a major overhaul after 5 years.

Cost of the overhaul $12,000

Scrap (after 8 years) $15,000

Should the company buy the machine if the cost of capital is:

a) 12%

b) 5%

-for margins (12% at 8th period) - use annuity

-for overhaul - it’s not an annuity - so use the other table

Cash flows

When

Cash Effect

12% Factor

PV

PV 5%

Purcahse

Now

(200,000)

1.0

(200,000)

(200,000)

Margins

1-8

35,000

4.968

173,880

226,205

Overhaul

5

(12,000)

0.567

(6,804)

(9,408)

Scrap

8

15,000

0.404

6,060

10,155

Total

(162,000)

(26,864)

26,952

Only pages 1-2 are available for preview. Some parts have been intentionally blurred.

Example 2: A 55 year old woman is deciding whether or not to open a business. She

wants to earn 12% on any investment. The business is sell a product & sell a service.

Sales and cost data are as follows:

1. Equipment cost $200,000 required immediately and sold in 10 years for 5% cost

2. Working capital required $15,000 immediately and will be recovered in 10 years

3. Business rental space 10 year lease for $1,200 / month

4. Product selling price is $12.50 and the service selling price is $4.00

5. Variable costs: Product $4.25 and Service $0.75

•we buy something at $4.25

•sell it for $12.50

6. Product sales are estimated at $7,500 / month and 30% of the customers will use it

7. Monthly fixed costs above rent is $900

convert everything into annual / monthly terms

Annual Cash Flows

Sales - product (7,500 x 12) 90,000

- service (7,500 / 12.50 = 600) 8,640

(600 customers x 30% x $4 x 12 months)

Total 98,640

Variable Costs - product (600 x 4.25 x 12) 30,620

- service (600 x 30% x 0.75 x 12) 1,620

Contribution Margin 66,400

Fixed Costs - rent (1,200 x 12) 14,400

- other (900 x 12) 10,800

Cash in every year 41,220

now you calculate the net profit value (NPV)

Therefore, go ahead with the business bc you’re earning more than 12%.

Item

Value

When

Factor

PV

Equipment

200,000

today

1.0

(200,000)

Working

Capital

15,000

today

1.0

(15,000)

Annual Cash

Flows

41,220

1-10

use annuity table

5.650

232,893

Sell

Equipment

10,000

5% of 200,000

10

single payment so

NOT the annuity

table

0.322

3,860

W/C Recovery

15,000

10

0.322

4,830

Total

25,943

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