Making capital investment decisions is a crucial aspect of long-term financial decision making. In order to make these decisions, financial techniques are utilized to analyze the potential return on investment and the risks associated with the investment. This assignment will focus on three specific calculations: the payback method, the internal rate of return (IRR), and the net present value (NPV).
To understand these calculations, it is necessary to refer to the relevant sections of Chapter 7 in the textbook. The specific sections of Chapter 7 that should be reviewed for each calculation are as follows:
1. Payback Method: Review the section on the payback method in the textbook, particularly Exhibit 7-2 “Cash flows for two alternative project investments” and Exhibit 7-3 “Calculation of payback year for two alternative investments” on pages 308 and 309, respectively.
2. Internal Rate of Return (IRR): Review the section on unequal cash flows and Exhibit 7-8 “Using Excel to Calculate the IRR… that yields unequal operating cash flows…” (This can also be used for equal cash flows) on pages 318-319 of the textbook.
3. Net Present Value (NPV): Review the section on using spreadsheets to calculate NPV and Exhibit 7-6 “Using Excel to calculate the net present value of unequal annual cash flows” (This can also be used for equal annual cash flows) on page 316 of the textbook.
Once the relevant sections of the textbook have been reviewed, the next step is to read scenario #15 (Kaiser Oakland Practice) on page 329. This scenario provides the necessary information to perform the calculations. It is important to carefully read and understand the scenario before proceeding to the calculations.
The calculations should be completed in an Excel spreadsheet with three tabs, each corresponding to one of the calculations. Each tab should only include the results of the particular calculation being performed.
First, let’s discuss the payback method. The payback method is a simple and straightforward method of evaluating an investment by determining how long it takes to recover the initial investment. This method focuses on the cash inflows and outflows associated with the investment and identifies the point at which the cash inflows equal the initial investment.
To calculate the payback period, the cash inflows for each period are subtracted from the initial investment until the cumulative cash inflows equal or surpass the initial investment. The payback period is then determined by identifying the year in which this occurs.
To perform the payback calculation for the Kaiser Oakland Practice scenario, the cash inflows for each year are necessary. These cash inflows can be found in the scenario provided on page 329. By subtracting the cash inflows from the initial investment each year and keeping track of the cumulative cash inflows, the payback period can be determined.
The next calculation is the internal rate of return (IRR). The IRR is the discount rate that equates the present value of the cash inflows with the present value of the cash outflows. In other words, it is the rate of return that makes the NPV of the investment equal to zero.
To calculate the IRR, the cash inflows and outflows for each period are discounted to their present values using the appropriate discount rate. The discount rate is then adjusted until the NPV of the cash flows equals zero. This adjusted discount rate is the internal rate of return.
In the Kaiser Oakland Practice scenario, the cash inflows and outflows for each period are provided. Using the cash flows and a trial and error approach, the discount rate can be adjusted until the NPV of the cash flows equals zero, thus determining the internal rate of return.
The final calculation is the net present value (NPV). The NPV is a measure of the profitability of an investment by discounting all the cash inflows and outflows to their present values and subtracting the initial investment.
To calculate the NPV, the cash inflows and outflows for each period are discounted to their present values using the appropriate discount rate. The present value of each cash flow is then summed, and the initial investment is subtracted from this sum to obtain the NPV.
In the Kaiser Oakland Practice scenario, the cash inflows and outflows for each period are provided. By discounting these cash flows and summing them, and then subtracting the initial investment, the NPV of the investment can be calculated.
In conclusion, the calculations of the payback period, internal rate of return, and net present value are essential in determining the viability of a capital investment decision. Reviewing the relevant sections of Chapter 7 in the textbook and understanding the provided scenario are crucial in performing these calculations accurately. By completing these calculations in an Excel spreadsheet and organizing them into separate tabs, each calculation can be easily presented and evaluated.
