Capital Investment Techniques

In this assignment you will demonstrate your understanding of capital investment techniques by evaluating the following three case studies. 

How much money will be in the bank account if you leave the $300,000 alone until you need it in five years? 

Answer: 

Calculate the compound interest using the formula 

A=P (1+R)^n 

Where A= amount at end of period 

P= the amount you deposit today 

R= interest rate 

N= time in years 

So A= 300,000(1+0.06)^5 

A=$ 401,467.67 

This means you will have that amount if you leave it in the account after five years. 

If you undertake the investment opportunity, what is the Nominal Payback Period? 

Payback Period is the point where the cash inflows are equal to cash outflows i.e. when the investment recoups the initial outlay. 

Calculating PBP 

90,000+115,000+135,000=340,000 

Our initial amount will be recovered in the third year where the inflows will get to $ 300,000 in year 3 

Using the factors for 6%, what is the Discounted Payback Period? 

To calculate discounted PBP we use the formula of compound interest 

Discounted Cash Inflow = Actual Cash Inflow/(1 + i) n 

Year amount discounting factor discounted amount cumulative cash inflows 

1 90,000 1.06 88,679.25 88,679.25 

2 115,000 1.124 101,423.49 190,102.74 

3 135,000 1.191016 112,500.98 302,611.72 

From the calculations above, the PBP is in year three after calculating the discounted cash inflows at a rate of 6% 

What is the Present Value of the benefits from this 5-year investment opportunity? 

Year inflow-cash PVIF$1=1/(1+r)^n discounted cash flow cumulative cash 

1 90,000 0.9434 88,679.25 88,679.25 

2 115,000 0.8900 101,459.59 190,138.84 

3 135,000 0.8396 112,500.98 302,647.82 

4 110,000 0.7921 90,298.68 392,946.50 

5 90,000 0.7473 70,242.27 463,188.77 

The present value of total in flows =$ 463,188.77 

What is the Net Present Value of this opportunity? 

NPV =Pv cash inflows- Pv Cash out flows 

= 463,188.77-300,000= 

163,188.77 

If you leave the money in the bank and earn 6% compounded annually, will you have at least $450,000 in 5 years to fund the server and IT upgrades? By how much will you be “over” or “short” of what you need? 

If you leave the money in the bank at a compound interest rate of 6% , you will have =$ 401,467.67 which is $ 48,538.33 short. 

If you undertake the investment, will you have at least $450,000 in 5 years? By how much will you be “over” or “short”? 

If you invest in the project after five years you will get $ 463,188.77 which is $ 13,188.77 more. 

Case Analysis 2 - Weight 30% of total assignment 

Calculate the Nominal Payback, the Discounted Payback, the Net Present Value and the IRR assuming: 

Part A, BASE CASE: 3 year project life, flat annual savings, 10% discount rate 

Nominal PBP 

Year Savings accumulated savings 

1 65,000 65,000 

2. 65,000 130,000 

3. 65,000 195,000 

To get the exact PBP we assume the $ 65,000 is accrued evenly in the months of the year such that monthly savings =65, 0000/12=5,416.67 

For year three we need $ 20,000 to completely get back our initial outlay which will be four months of savings. 

Our PBP is therefore 2 years and 4 months. 

Discounted PBP 

Year Amount PVIF$1=1/(1+r )^n Discounted amount accumulated 

1 65,000 1.1 59,090.91 59,090.91 

2 65,000 1.21 53,719.00 112,809.91 

3 65,000 1.331 48,835.46 161,645.37 

The PBP is 150,000-112,809.91=37,190.09 

Assuming the 48,835.46 was accrued evenly,37,190.09/4069.62=9.14 

The PBP=2 years and 9.1 months. 

Net Present value 

Year amount PVIF$1=1/(1+r)^n discounted amount accumulated 

0 -150,000 1 -150,000 -150,000 

1 65,000 1.1 59,090.91 59,090.91 

2 65,000 1.21 53,719.00 112,809.91 

3 65,000 1.331 48,835.46 161,645.37 

NPV= -150,000+161,645.37=11,645.37 

Internal Rate of Return 

This is the rate at which NPV=0 

This rate in this scenario is 14% 

See excel for calculations 

Part B. Saving Growth Scenario: BASE CASE but with 10% compounded annual savings growth in years 2 & 3. 

Cash flows for the project 

Year 0 -150,000 

Year 1 65,000 

Year 2 78,650 

Year 3 86,515 

Nominal PBP 

Year amount accumulative 

1 65,000 65,000 

2 78,650 143,650 

3 86,515 230,165 

To get the exact PBP we calculate cumulative earnings for year 3 

86,515/12=7,209.58 

So the PBP is two years and approximately 1 month 

Discounted PBP 

Year amount discounting factor amount cumulative 

1 65,000 1.1 59,090.91 59,090.91 

2 78,650 1.21 65,000 124,090.91 

3 86,515 1.331 65,000 189,090.91 

The PBP=65,000/12=5415.67 

150,000-124,090.91=25,909.09 

25,909.09/5415.67=4.7 

PBP = 2 years and 4.7 months 

Net Present value 

Year amount discounting factor amount cumulative 

0 -150,000 1 -150,000 -150,000 

1 65,000 1.1 59,090.91 59,090.91 

2 78,650 1.21 65,000 124,090.91 

3 86,515 1.331 65,000 189,090.91 

NPV =-150,000+189,090.91=$ 39,090.91 

FOR IRR SEE EXCEL 2B 

Part C, Higher Discount Rate Scenario: 3 year project life, flat annual savings, 15% discount rate 

Nominal PBP 

Nominal PBP 

Year Savings accumulated savings 

1 65,000 65,000 

2. 65,000 130,000 

3. 65,000 195,000 

To get the exact PBP we assume the $ 65,000 is accrued evenly in the months of the year such that monthly savings =65, 0000/12=5,416.67 

For year three we need $ 20,000 to completely get back our initial outlay which will be four months of savings. 

Our PBP is therefore 2 years and 4 months. 

Discounted PBP 

Year amount discounting factor amount-discounted cumulative 

1 65,000 1.15 56,521.74 56,521.74 

2 65,000 1.3225 49,149.34 105,671.08 

3 65,000 1.52088 42,738.41 148,409.49 

With this option, we do not meet the amount to get PBP. 

NPV 

Year amount discounting factor amount discounted cumulative 

0 -150,000 1 -150,000 -150,000 

1 65,000 0.8696 56,524 93,476 

2 65,000 0.7561 49,146.5 105,670.5 

3 65,000 0.6575 42,737.5 148,408 

NPV=-150,000+148,408=-1,592 

IRR see excel 2c 

Rate=14% 

Part D, 5 Year Equipment Life:5 year project life, flat annual savings, 10% discount rate 

Nominal PBP 

Year amount cumulative amount 

1 65,000 65,000 

2 65,000 130,000 

3. 65,000 195,000 

To get the exact PBP we assume the $ 65,000 is accrued evenly in the months of the year such that monthly savings =65, 0000/12=5,416.67 

For year three we need $ 20,000 to completely get back our initial outlay which will be four months of savings. 

Our PBP is therefore 2 years and 4 months. 

Discounted PBP 

year	amount	discounting factor	discounted amount	cumulative amount
0	-150,000	1	-150000	-150000
1	65,000	0.909091	59090.91	59090.91
2	65,000	0.826446	53719.01	112809.9
3	65,000	0.751315	48835.46	161645.4
4	65,000	0.683013	44395.87	206041.3
5	65,000	0.620921	40359.89	246401.1

PBP= 3 years 

NPV 

year	amount	discounting factor	discounted amount	cumulative amount
0	-150,000	1	-150000	-150000
1	65,000	0.909091	59090.91	59090.91
2	65,000	0.826446	53719.01	112809.9
3	65,000	0.751315	48835.46	161645.4
4	65,000	0.683013	44395.87	206041.3
5	65,000	0.620921	40359.89	246401.1

								NPV = 96,401.14

IRR=33% 

REFER TO EXCEL SHEET NPVIRR 

Discussion – in a Word Document in paragraph form, respond to the following: 

From a Financial perspective, would you recommend this purchase to Management? Which scenario would you present and why? 

I would recommend option D, this is because it has a shorter PBP, higher NPV and higher IRR 

In your opinion, which scenario is the most aggressive? If you were to select this scenario as the basis for your proposal, how would you justify the more aggressive economics? 

The most aggressive option is B where we have to compound the cash inflows for years 2 and three. This would require having the inflows re-invested immediately after being realized. 

In SIMPLE English (as in talking to a non-Finance and non-MBA person), explain why there was a difference in outcome between Part A and Part B. 

The difference between option A and B is that we are compounding the acquired earnings from the project making the earnings for part B higher than those in A. 

Beyond Financial measures, what other considerations would you want to consider, before making a recommendation to Management? 

Other factors to consider include. 

Current economic conditions 

Likely changes in technology 

Government regulations 

Tax changes 

Case Analysis 3 – Weight 40% of total assignment 

You are the General Manager at the Bicker, Slaughter and Lynch Law Firm. There is an opportunity to buy out a small law firm that was just started by a young MBA/JD and you believe the firm can be grown and become a lucrative part of your Firm. 

With help from your Finance leader, you have estimated the following benefit streams for this new division: 

Year 1 

Year 2 

Year 3 

Year 4 

Year 5 

Year 6 

Year 7 

Year 8 

Before Tax 

Cash Flow 

From 

Operations 

$(149,000) 

$- 

$51,380 

$88,760 

$114,100 

$129,780 

$143,640 

$167,300 

After Tax 

Net Income 

From 

Operations 

$(103,500) 

$(50,500) 

$36,700 

$63,400 

$81,500 

$92,700 

$102,600 

$119,500 

After Tax 

Cash Flow 

From 

Operations 

$(85,600) 

$15,000 

$48,600 

$72,200 

$95,550 

$101,300 

$125,200 

$140,200 

You estimate that the purchase price for this firm would be $200,000 and that additional net working capital would be needed in the amount of $60,000 in year 0, an additional $20,000 in year 2 and then $20,000 in year 5. 

In addition to the purchase price, you would ask that your Advertising budget of $275,000 be increased by an incremental one time amount of $50,000 in advertising in year 0 to publicize the firm’s expansion. 

Your Finance leader has indicated that the firm has access to a credit line and could borrow the funds at a rate of 6%. (Assume the cash associated with this interest is included in the above benefit numbers ). He also mentions that when he runs Project economics for Capital budgeting (such as a new copier or a company car), he recommends a standard 10% rate discount but the one other time they looked at an acquisition of a smaller firm he used a 12% rate discount 

At the end of 8 years, the plan will be to sell this division. The estimated terminal value (the sale and the return of working capital) is conservatively estimated to be $300,000 of cash flow help. 

Calculate the N Nominal Payback, the Discounted Payback, the Net Present Value and the IRR for this potential acquisition. 

calculating the nominal PBP
YEAR	AMOUNT	CUMMULATIVE AMOUNT
0	-585,000	-585,000
5	-20,000	-605,000
1	-85,000	-85,000
2	15,000	-70,000
3	48,600	-21,400
4	72,200	50,800
5	95,550	146,350
6	101,300	247,650
7	125,200	372,850
8	140,200	513,050
PBP	from the above cumulative cash flow from operations we do not have a PBP
	513,050 is less than the initial amount of 605,000

calculating the discounted PBP
YEAR	Amount	discounting factor 1/(1+r)^n	discounted amount	cumulative amount
0	(585,000.00)	1	(585,000.00)	(585,000.00)
5	(20,000.00)	0.567427	(11,348.54)	(596,348.54)
1	(85,000.00)	0.892857	(75,892.86)	(75,892.86)
2	15,000.00	0.797194	11,957.91	(63,934.95)
3	48,600.00	0.71178	34,592.52	(29,342.43)
4	72,200.00	0.635518	45,884.41	16,541.98
5	95,500.00	0.567427	54,189.26	70,731.24
6	101,300.00	0.506631	51,321.73	122,052.97
7	125,200.00	0.452349	56,634.12	178,687.10
8	140,200.00	0.403883	56,624.43	235,311.52
8	300,000.00	0.403883	121,164.97	356,476.49
total				(370,717.47)

The discounted PBP is not achieved by our cash inflows from operations. 

Calculating NPV 

calculating the discounted NPV
YEAR	Amount	discounting factor 1/(1+r)^n	discounted amount	cumulative amount
0	(585,000.00)	1	(585,000.00)	(585,000.00)
5	(20,000.00)	0.567427	(11,348.54)	(596,348.54)
1	(85,000.00)	0.892857	(75,892.86)	(75,892.86)
2	15,000.00	0.797194	11,957.91	(63,934.95)
3	48,600.00	0.71178	34,592.52	(29,342.43)
4	72,200.00	0.635518	45,884.41	16,541.98
5	95,500.00	0.567427	54,189.26	70,731.24
6	101,300.00	0.506631	51,321.73	122,052.97
7	125,200.00	0.452349	56,634.12	178,687.10
8	140,200.00	0.403883	56,624.43	235,311.52
8	300,000.00	0.403883	121,164.97	356,476.49
total				(370,717.47)

NPV=-370,717.47 

CALCULATING THE IRR 

IRR=4% See the workings in excel for question three sheet 

Discussion – in a Word Document in paragraph form, respond to the following: 

From a Financial perspective, would you recommend this purchase to Management? Why? 

I would not recommend this purchase to the management. This is due to the fact that there is no payback period even after 8 years of operation. The total cash flow is still below the amount invested in the business. The net present value of the business returns a negative value; this implies that there is no financial benefit derived from the new business. A negative net present value also imply that the net cash outflow is higher than the inflow, the liabilities from the operations of new office will, therefore, be higher than the income obtained from the project. An internal rate of return of 33% shows that the business is unlevered, I would, therefore, not recommend the takeover on any business. 

What are some of the non-financial elements that would change your initial recommendation made in question? 

The non-financial elements include an increased goodwill of the new business, changes in the perception of the clients which can be perceived in the terms of their new preferences, tastes, and choices, as well as the government policy. A change in the economic conditions and the length that is required to complete the project is essential for the acquisition of the new business. 

Assumptions in Project Economics can have a huge impact on the result. Identify 3 elements/assumptions in your analysis that would make this project not be financially attractive? 

In order for the project to be a bad decision then the net present value must be a negative value, negative value of net profit value indicates that the present cash inflow is higher than the present cash outflow. The rate of return which is a single digit shows that the business is operating at a very low profitability level. The payback period must not be achieved in the process. This ensures that the money invested in the acquisition cannot be regained by the process.