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PROFESSOR: All right, I hope that everybody just looked at
the problems assigned, 10.1 and 10.5 that used net present
value and internal rate of return to evaluate the
problems as opposed to what the textbook said.
If you did use payback or ROA, give me a call or email me and
I'll send you the solutions.
I didn't assign you homework problems for ROA on payback,
because those are usually fairly simple to calculate.
On the study guide, we do have two problems, so if you're
having challenges with either or those, let me know, or any
four of the valuation methods, let me know, and we can talk
through them.
All right, so, on 10.1, the consideration or the problem
is that we're investing $100,000 in a restaurant, and
we have four cash flows from that investment of 10,000,
30,000, 40,000, and 60,000.
So, we first want to do net present value.
And what net present value asks us is, is the present
value of the cash flows equal or greater than the initial
investment.
If the present value of the cash flows are equal or
greater than the initial investment, than we accept.
If they're not, then we decline.
All right.
So, we go ahead and we look at our present value for a single
cash flows table, and at 10%, we go down from one through
four, and we get our 0.9091 0.8264, on to 0.6830.
And we go ahead and do our math across.
A $100,000 investment is a negative.
I guess I have an extra comma in the present value.
But we all know that's $100,000.
So, at time period zero, we invest $100,000, and then at
time period 1, we get 10,000.
When we discount that, it's a $9,091 dollars.
In year two, we discount that one by using the multiplier.
We get 24,792.
As you can see, doing these on Excel--
I did this on Excel--
it's really easy to do.
And once you set up a formula, it makes doing the internal
rate of return real simple.
Unfortunately, we can't do that on the test, So we go
ahead and we do our math.
We multiply, we discount all four of those cash flows, and
then we add everything up.
I just went ahead and summed everything because my $100,000
is negative, and I get 4,915, and we accept.
Now, the way that the net present value usually works is
that we would accept every project that met our case B,
our line in the sand as far as interest rate.
So, if we had two accept, we'd accept them both.
If I asked you which one was best, which probably isn't a
great thing to do, but if I do, and they're both accept,
you take the one with the larger net present value.
OK, so, now how you do IRR.
If we go back, we notice that we accept this in 10%, and
that should be a cue to tell us that the interest rate is
higher than 10%.
So, when we start doing IRR, we should go above.
And I went ahead and I plugged in 12%, and I got real lucky.
The net present value when the IRR is 12%
is about 528, negative.
It doesn't matter if that present value's positive or
negative when we're doing internal rate of return.
We just want to get close to zero.
So, I did real well.
I got lucky.
The internal rate of return for this investment is about
12%, and that would be your answer.
If you wanted to be sure, you can go up to 14 and down to
11, see if it gets any closer.
I don't know if you noticed, but the textbook
does not have a 13%.
And I could tell you how to calculate 13%, but since we're
not going to need it, we're not going to worry about it.
If you do want to know how to calculate the 13%, please let
me know and I will give you the information.
OK.
10.5, we have two alternatives.
We have alternative A--
I've got 1 and 2.
And I just copied this straight out of the book, and
I did this so that we can go ahead and do
our net present value.
Now, what we're doing is we're comparing two investments and
we're choosing one based on net present value over the
other one, and then one based on IRR over the other one.
Of course they'll be the same one because net present value
and IRR use the same criteria.
So, alternative one, again, at 10% I go and I look in the
book and I get my PV for 10% for five years, and that's
that 0.901 all they way down to 0.6209.
I do my math and I add up the present value of all my cash
flows, and I get 17,441, which is positive, so I accept
alternative one.
Alternative two, I'm doing net present value.
I do all the math and I get a negative 6,447.
That tells me that I reject this one.
Now, the next part of this is to calculate the IRR.
So, if we go back to alternative one, we know that
the internal rate of return on this investment is higher than
10%, probably much higher.
And by the same token, when we look at alternative two, we
know that the IRR is lower than 10%, because we did not
accept it at 10%.
So, first thing I did is I plugged in 12% in my
calculator, then I pressed Value and I got 8,050.
I think I can probably do better than that, so I went
ahead and I plugged in 14%, and I got
about a negative 3,343.
So, it's a little bit less than 14% and it's more than
12%, so I would assume that this is about 14%.
If you put the IRR is about 14%, you're going to be fine.
Because we're calculating these by hand, I just want you
to make sure that you're using the closest interest rate.
On the test, they're going to be a little bit
cleaner than this.
They're not going to be exactly zero, but they're
going to be close.
There's going to be one sound answer.
All right.
And the second alternative, I plugged in 8% and net present
value went down to negative 2,729.
I thought I could get closer, so I plugged in 7% and I got a
net present value of 772 negative.
So my answer is that the internal rate of return on the
second investment or the alternative two is about 7%.
Again, this is hit and miss.
On the first problem I got lucky at 12%.
On the second problem, I had to do two or three
calculations.
They're really timely if you're doing them by hand, but
if you're doing them on Excel, they go a lot quicker.
You will have a problem on the test similar to your study
guide problem for the chapter.
So, your next homework assignment is actually one of
your problems on the test, or comparable to one of your
problems on the test.
All right.
Let's go ahead and get back to work.