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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-1
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Capital Budgeting
Chapter 10
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-2
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Learning Objectives
Understand the purpose and need for capital budgeting. Explain the impact that government regulations may have
on a company’s capital budgeting decision. List and explain the steps required in making a capital
budgeting decision. Distinguish between startup costs, working capital
commitment costs, and tax factor costs and the role each plays in the capital budgeting decision.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-3
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Compare the relationship between increased efficiency benefits and tax factor benefits and understand their effect on a company’s cash flow.
Understand payback, net present value, profitability index, internal rate of return, and accounting rate of return as techniques of capital budgeting.
Compute the payback of a capital budgeting project. Using time value of money, compute the net present value
of a capital budgeting project.
Learning Objectives (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-4
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Given a company’s investment costs, calculate the weighted average cost of capital.
Calculate and compare a company’s internal rate of return to its accounting rate of return.
Determine how a company’s capital budgeting decision makes a project mutually exclusive.
Determine how a company’s capital budgeting decision is influenced by capital rationing.
Understand the importance of following up, controlling, and taking corrective action after a capital budgeting decision has been made.
Learning Objectives (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-5
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Capital Budgeting
Capital budgeting is the method we use to justify the acquisition of capital goods (those items that have a useful life in excess of one year).
Assumptions:› Long-term assets generate increased cash flow by improving
efficiency and effectiveness.› Rates of return on investments and current inflation rate will
remain the same.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-6
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Factors Affecting Capital Budgeting
Changes in government regulations Research and development Changes in business strategy
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-7
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Steps in Capital Budgeting
Formulate a proposal Evaluate the data Make a decision Follow up Take corrective action
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-8
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Formulating a Proposal Costs in capital budgeting
› Startup costs› Working capital commitment cost› Tax factor costs
Benefits in capital budgeting› Increased efficiency› Reducing taxable income› Tax factor benefits› Depreciation
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-9
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Table 10-1 Annual Interest Payments and Tax Savings for a Five-Year LoanAmount
Borrowed Annual Interest
RateNumber of
MonthsMonthly Payment
Income Tax Rate
100,000.00$ 11.00% 60 $2,174.24 28.00%
1 26,090.91$ 15,875.48$ 10,215.43$ $2,860.322 26,090.91 17,712.57$ 8,378.34 2,345.943 26,090.91 19,762.24$ 6,328.67 1,772.034 26,090.91 22,049.11$ 4,041.80 1,131.705 26,090.91 24,600.61$ 1,490.30 417.28
Totals 130,454.54$ 100,000.00$ $30,454.54 $8,527.27Note: Rounding may cause what appears to be an error of a penny in some columns.
Principal Payment
Interest Payment Tax SavingsYear
Annual Loan Payment
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-10
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Evaluating the Data-techniques of Capital Budgeting
There are six methods that are used to evaluate the capital budgeting proposal.1) Payback
2) Net present value (NPV)
3) Profitability index (PI)
4) Internal rate of return (IRR)
5) Accounting rate of return (ARR, also known as average rate of return)
6) Lowest total cost (LTC)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Payback
Payback deals with the number of years that it will take a business to get back the money that it has invested in a project or asset.
ATB
CPayback
WhereC = Cost of the project
ATB = Annual after-tax benefit of the project
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Net Present Value, or NPV
The net present value method of capital budgeting uses the time value of money by discounting future benefits and costs back to the present. › It applies the present-value-of-a-stream-of-payments technique for
even cash flows and the present-value-of-a-future-lump-sum technique for unequal yearly cash flows.
› The calculations are made using an interest rate that matches our cost of capital for the investment. This rate is used because the company must pay this cost on an annual basis to obtain the financial capital necessary to make the investment.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
There are two interest rates that we must consider: 1) The interest rate charged by the supplier of funds, or the lender
2) The interest rate that the borrower could receive by investing in some other enterprise (the latter is the borrower’s opportunity cost)
Net Present Value, or NPV (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
There are three components that determine the lenders’ interest rate:1) The real rate of return (the return that will be received after
factoring out inflation)
2) The inflation premium (the expected average inflation rate for the term of the investment)
3) The risk premium (the rate added to the interest rate to take into account the risk of the investment)
Net Present Value, or NPV (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Weighted average cost of capital (WACC) is obtained by multiplying the cost of debt (rate that the lender charges) by its proportion of total funds raised, and multiplying the cost of equity (opportunity cost to the owner) by its proportion of total funds raised.
Net Present Value, or NPV (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
WACC Example: You are buying a piece of equipment for $100,000. You will put $30,000 down and finance the remaining $70,000. Your opportunity cost is 4.00% for the $30,000 and 8.75% for the $70,000 loan.
Net Present Value, or NPV (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Net Present Value, or NPV (continued)
Calculations of WACC:
70.0000,100$
000,70$
Paidamount Total
FinancedAmount ProportionDebt
30.0000,100$
000,30$
Paidamount Total
equity sOwner' ProportionEquity
$100,000 $70,000 $30,000
paidamount Total financedamount equity sOwner'
7.33%or 0.0733,
0.06130.0120
.70)(0.0875)(0 0)(0.04)(0.3
)proportion cost)(Debt(Debt )proportionty cost)(Equi(Equity WACC
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-18
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
NPV considers all of the future cash flows over the asset’s entire economic life.
Net Present Value, or NPV (continued)
PVCPVBNPV Where
NPV = Net present value of the investment
PVB = Present value of the benefit as calculated in the following example
PVC = Present value of the cost of the investment as calculated in the following example
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Making the decision using NPV:› If NPV is positive using the WACC, the investment should be
made.› If NPV is negative using the WACC, the investment should not
be made.
NPV has two primary advantages:1) Future cash flows that will be paid and received can be
discounted back to the present so that a decision on the investment can be made now.
2) Interest rates are determined by and based on the weighted average cost of capital that takes risk into consideration.
Net Present Value, or NPV (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Net Present Value, or NPV (continued)
Table 10-2 NPV of an Automobile Purchase
Present PresentBENEFITS PVAF at Value PVAF at Value
Item 10.00% at 10% 14.00% at 14%Cash flow $10,000.00 per year 3.7908 $37,908.00 3.4331 $34,331.00Salvage value $4,000.00 end of 5 years 0.6209 2,483.60 0.5194 2,077.60PVB $40,391.60 $36,408.60
COSTSPurchase price ($20,000.00) Present Value ($20,000.00) ($20,000.00)Insurance ($100.00) per month 47.4576 (4,745.76) 43.4784 (4,347.84)Gas and maintenance ($300.00) per month 47.4576 (14,237.28) 43.4784 (13,043.52)PVC ($38,983.04) ($37,391.36)
NPV=PVB-PVC $1,408.56 ($982.76)
Cash Flow per time period
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-21
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Profitability Index, or PI
The profitability index is the ratio of the present value of the benefits to the present value of the costs.› If PI>1, benefits outweigh costs, invest in project.› If PI<1, costs outweigh benefits do not invest in project.› If PI=1, costs and benefits are equal.
The formula for PI is:
PVC
PVBPI
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Internal Rate of Return, or IRR
The internal rate of return is the actual rate of return of an investment and uses the time value of money in its calculation. The IRR is the interest rate that matches the present value of the cost of our investment directly with the present value of the future benefits received.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-23
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
The future benefits can be in the form of a stream of payments over a period of time or a lump sum (salvage value) received.
The IRR is the interest rate that occurs when the NPV is zero. If the NPV is zero, then by definition, the present value of the costs must equal the present value of the benefits.
The IRR is an interest rate that corresponds to a present value annuity factor that is found by dividing the present value of the cost by the period’s cash flow.
Internal Rate of Return, or IRR (continued)
flow cash sPeriod'
investment the of cost the of valuePresent factorIRR
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Internal Rate of Return, or IRR (continued)
Table 10-4, Present Value of an Unequal Stream of Projected Cash Benefits
Projected
PVF Factor for Interest of
Present Value in
PVF Factor for Interest of
Present Value in
Year Cash Flow 20.00% Dollars 25.00% Dollars1 21,000.00$ 0.8333 17,499.30$ 0.8000 16,800.00$ 2 29,000.00 0.6944 20,137.60 0.6400 18,560.00 3 36,000.00 0.5787 20,833.20 0.5120 18,432.00 4 16,000.00 0.4823 7,716.80 0.4096 6,553.60 5 8,000.00 0.4019 3,215.20 0.3277 2,621.60
Total PV 69,402.10$ 62,967.20$
Table 10-3, Five-Year Projected Cash FlowInitial Investment: 66,000.00$
Year Projected Cash Flow
1 21,000.00$ 2 29,000.00 3 36,000.00 4 16,000.00 5 8,000.00
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-25
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Internal Rate of Return, or IRR (continued)
This is interpolation based on the data in the previous tables:
90.434,6$10.402,3$
00.000,66$
10.402,69$20?
5
$62,967.20---25
x
%64.22%6435.2%20?
6435.290.434,6$
50.010,17$
)90.434,6($
)10.402,3)($5(?
90.434,6$
10.402,3$
5
?
20.967,62$10.402,69$
00.000,66$10.402,69$
2520
?
25%PV$)-(20%PV$ distance Total
x%PV$)-(20%PFV$ distance Partial?
1
21
iIRR
ii
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-26
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Accounting Rate of Return, or ARR
The accounting rate of return is the average annual income from a project divided by the average cost of the project.
The formula is:
life its over investment of cost Average
income annual AverageARR
› Example: Invest $10,000. Receive royalties of $3,000 per year. Using ARR, $3,000 divided by $10,000 is a 30% accounting rate of return.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-27
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Lowest Total Cost
The lowest total cost (LTC) method of capital budgeting is similar to the net present value (NPV) method because it uses the time value of money by discounting future costs and benefits back to the present.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
The method used to determine the lowest present value of total cost is as follows:› Include all costs associated with two or more competing
investments. › Calculate the present value of these costs. Add the present value of
any benefits (salvage value) that may be obtained on the investment.
› Select the investment with the lowest overall total cost.
Lowest Total Cost (continued)
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-29
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Lowest Total Cost (continued)
Table 10-5 Lowest Total Cost (LTC) of a Truck Purchase
Category QuantityFuel cost per gallon 3.97$ Annual Mileage 25,000WACC 12.00%Ownership in years 6PVAF Table B-5 or Formula 4.1114PVF Table B-2 or Formula 0.5066
Category(Costs) and
Benefits PV(Costs) and
Benefits PV(Costs) and
Benefits PVMileage Per gallon 16 13 15Purchase Price (26,955.00)$ (26,955.00)$ (25,695.00)$ (25,695.00)$ (30,556.00)$ (30,556.00)$ Annual Fuel Costs (6,203.13) (25,503.57) (7,634.62) (31,389.01) (6,616.67) (27,203.81) Annual Insurance Cost (1,347.40) (5,539.71) (1,532.44) (6,300.49) (1,358.52) (5,585.43) Salvage Value 10,800.00 5,471.62 10,800.00 5,471.62 12,250.00 6,206.23 Total Cost for 6 Years (52,526.66)$ (57,912.88)$ (57,139.01)$
Truck Model A Truck Model B Truck Model C
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-30
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Making the Decision The methods previously discussed are often used in
making a capital budgeting decision. However, two other scenarios exist.› Mutually Exclusive: Some investments are mutually exclusive
because one is chosen and the others are automatically sacrificed or excluded.
› Capital Rationing: Capital rationing is a constraint placed on the amount of funds that can be invested in a given time period.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Capital Cumulative NetBusiness Investment Investment PresentLocation Cost Cost Value
1 50,000$ 50,000$ 125,000$ 2 46,000 96,000 121,000 3 52,000 148,000 119,000 4 47,500 195,500 116,000 5 67,300 262,800 115,000 6 48,000 310,800 113,000 7 63,000 373,800 112,500 8 48,700 422,500 111,000 9 54,200 476,700 110,250 10 62,500 539,200 (15,000) 11 48,500 587,700 (17,000) 12 65,000 652,700 (25,000)
Table 10-6 Capital Budgeting Choices
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-32
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Following Up› Following up consists of monitoring and controlling our cash
flows. › A post-audit requires the owner or manager to establish
procedures that will determine how well the outcome of the decision correlates with the proposal.
› Controlling, as we have said before, is a three-step process: (1) establish standards for measuring the project, (2) measure actual performance against the standards established, and (3) take corrective action if required.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-33
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Table Solutions to Problems
The following slides contain the Excel spreadsheets for problems that require solutions using tables.
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-34
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Answer to problem 6a Cost of
capital = 10.00%
Year Amount PV Factor Present Value1 21,000 0.9091 $19,090.912 29,000 0.8264 23,966.94 3 36,000 0.7513 27,047.33 4 16,000 0.6830 10,928.22 5 8,000 0.6209 4,967.37
$86,000.77
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-35
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Answer to problem 6b Cost of
capital = 20.00% Cost of
capital = 25.00%
Year Amount PV FactorPresent Value PV Factor
Present Value
1 21,000 0.8333 $17,500.00 0.8000 $16,800.002 29,000 0.6944 20,138.89 0.6400 18,560.00 3 36,000 0.5787 20,833.33 0.5120 18,432.00 4 16,000 0.4823 7,716.05 0.4096 6,553.60 5 8,000 0.4019 3,215.02 0.3277 2,621.44
$69,403.29 $62,967.04
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Entrepreneurial Finance, 5th EditionAdelman and Marks
10-36
Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Answer to problem 8b Cost of Capital= 8.00%
Item Cost PV Factor Present
Value
Install Cable 200.00$ 1 200.00$ Computer 5,100.00 1 5,100.00 Cable Usage Fee 50.00 40.9619 2,048.10
7,348.10$
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Answer to question 9
Item Freezer A PV Factor
Present Value Freezer B
Present Value
Investment required ($29,000) 1.0000 (29,000.00)$ ($25,000) (25,000.00)$ Annual electrical bill (3,000) 7.1390 (21,416.89) (4,000) (28,555.86) Salvage value 6,000 0.4289 2,573.30 5,000 2,144.41
(47,843.60)$ (51,411.44)$ Project life in years 11 11The LJB Company cost of capital is 8.00%
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Entrepreneurial Finance, 5th EditionAdelman and Marks
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Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458
Solution to problem 12c
Item Cost Time Period PV Factor PV of CostsFAX 500.00$ Now 1 500.00$ Installation 300.00 Now 1 300.00 Van down payment 4,000.00 Now 1 4,000.00 FAX service 60.00 per month 49.31844 2,959.11 Driver 600.00 per month 49.31844 29,591.06 Van maintenance 300.00 per month 49.31844 14,795.53 Van payment 305.62 per month 49.31844 15,072.70
Total monthly 1,265.62$ PV of total costs 67,218.40$
Note: 5-year expected lifetime 12 months per year = 60 monthly payments. Use ordinary annuity as we assume payments are made at the end of the month.