NPV and Capital Budgeting

NPV and Capital Budgeting

Part I: Net Present Value

A - Case 1

Bank Account Worth = $15,000

Discount Rate = 7%

NPV = ?

Present Value @ 7% = $15,000/1.07 = $14,018.69

A - Case 2

Bank Account Worth = $15,000

Discount Rate = 7%

NPV = ?

Present Value at 4% = $15,000/1.07 = $14,423.08

 

At 7%

At 4%

NPV

14,018.69

14,423.08

B - Case 1

Account A worth = $6,500

Period = 1 year

Interest rate = 6%

NPV = $6,500.00 /1.06 = $6,132.08

B - Case 2

Account B worth = $12,600

Period = 2 years

Interest rate = 6%

NPV = $12,600.00 /1.062 = $11,214

 

At 6%

At 6%

NPV

$6,132.08

$11,214

(C)

Worth of Goldmine

Year 1

$49,000,000

Year 2

$61,000,000

Year 3

$85,000,000

NPV of Goldmine

At 7% discount rate

=> $49,000,000/(1.07) + $61,000,000/(1.07)2 + $85,000,000/(1.07)3

=> $45,794,392.52 + $53,279,762.42 + $69,385,319.54

NPV = $168,459,474.48

At 5% discount rate

=> $49,000,000/(1.05) + $61,000,000/(1.05)2 + $85,000,000/(1.05)3

=> $46666666.67 + $55328798.19 + $73275862.07

NPV = $175271326.92

At 3% discount rate

=> $49,000,000/(1.03) + $61,000,000/(1.03)2 + $85,000,000/(1.03)3

=> $47572815.53 + $57547169.81 + $77981651.38

NPV = $ 183101636.72

 

At 7%

At 5%

At 3%

NPV

$168,459,474.48

$175,271,326.92

183101636.7

Part II: Capital Budgeting

A - NPV

Initial Investment

$400,000

Year 1

$100,000

Year 2

$120,000

Year 3

$850,000

 

At 0%

At 2%

At 6%

At 11%

 

Cash Flows

Year 0

-400,000

-400,000

-400,000

-400,000

Year 1

100,000

98039.22

94339.62

90090.09

Year 2

120,000

115384.6

107142.9

97560.98

Year 3

850,000

801886.8

714285.7

620437.96

 

 

 

 

 

NPV

670,000

615,311

515,768

408,089

B - NPV

Initial Investment

$815,000

Year 1

$141,000

Year 2

$320,000

Year 3

$440,000

 

At 1%

At 4%

At 10%

At 18%

 

Cash Flows

Year 0

-815,000

-815,000

-815,000

-815,000

Year 1

139,604

135576.9

128181.8

119491.53

Year 2

313,725

296296.3

264462.8

230215.83

Year 3

427,184

392857.1

330827.1

268292.68

 

 

 

 

 

NPV

65,514

9,730

-91,528

-197,000

IRR

3%

1%

-5%

-11%

Net Present Value

It is the most widely used method by the academicians, investors and financial managers to compare and select from a pool of investments. NPV is calculated in monetary terms. This method works on the basis of the concept of time value of money. It means that one pound sterling after one year is worth less than the same amount of money today. The reason is that the increasing inflation increases the cost of capital; as a result, the purchasing power of the same amount reduces as on today (Brealey and Habib, 2007, Pp. 12).

To incorporate the effect of increasing inflation and growth rate, this method discounts the future ...