Financial Decision Making

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 Schedule Update

Class Date Topic In class Assignment

Time Value of Money, Return on Investment (ROI) and Review Decision Making Assignment #1; Intro to
5 9-Nov Decision Making Assignment #1
Interest Rates Time Value of Money, ROI and Interest Rates
Time Value of Money, Return on Investment (ROI) and Decision Making Assignment #2, TVM/ROI Decision Making Assignment #2; review
6 14-Nov
Interest Rates (continued) (Cont'd) Time Value of Money, ROI slides
7 16-Nov Case #2 Decision Making**
Time Value of Money, Return on Investment (ROI) and
8 21-Nov Review TVM Assignment; Project Teams Check-in TVM Assignment
Interest Rates (continued)
23-Nov No Class - Thanksgiving Holiday
Intro to Customer Acquisition; Review TVM
9 28-Nov Customer Acquisition
Assignment
10 30-Nov Customer Acquisition (continued) Customer Acquisition Customer Acquisition Assignment
11 5-Dec Captial Budgeting Intro to Capital Budgeting No pre-class assignment
12 7-Dec Capital Budgeting Capital Budgeting Capital Budgeting Assignment
13 12-Dec Buffer class, course review
Case #3 (In-class individual assessment) covers
14 14-Dec TVM, Customer Acquisition & Capital Bugeting
**
* Denotes graded team assignment
** Denotes graded individual assignment

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 MOD 1 Feedback
• Stop
• Changing teams/let us choose teams
• “treating us like kids”; could cover a lot more
content
• Start
• Practical application “in business world”
• More practice real time
• Consider use of videos
• Slowing pace
• Free coffee

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 DECISION MAKING –
RELEVANT COSTS

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 Decision Making Assignment #1

A. The management of Abundanza Corporation is considering dropping Product A88. Data from the
company's accounting system appear below:

The company has typically allocated all fixed expenses of the company to products. Further
investigation has revealed that $34,000 of the fixed manufacturing expenses and $20,000 of the fixed
selling and administrative expenses are avoidable if product A88 is discontinued. What would be the
effect on the company's overall net operating income if product A88 were dropped? Be sure to put
BOTH amount and direction (INCREASE or DECREASE).

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 Decision Making Assignment #1

A. The management of Abundanza Corporation is considering dropping Product A88. Data from the
company's accounting system appear below:

The company has typically allocated all fixed expenses of the company to products. Further
investigation has revealed that $34,000 of the fixed manufacturing expenses and $20,000 of the fixed
selling and administrative expenses are avoidable if product A88 is discontinued. What would be the
effect on the company's overall net operating income if product A88 were dropped? Be sure to put
BOTH amount and direction (INCREASE or DECREASE).

Sales (130,000)
VC 56,000
CM (74,000)
Avoidable FC
Mgr 34,000
Selling 20,000
Change in NOI (20,000)

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 Decision Making Assignment #1 (Cont’d)
Pemulis Corporation makes 11,000 units of part W28 each year. This part is used in one of the
company's products. The company's Accounting Department reports the following costs of producing
the part at this level of activity:

An outside supplier has offered to make and sell the part to the company for $25.50 each. If this offer
is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided.
The special equipment used to make the part was purchased many years ago and has no salvage
value or other use. The allocated general overhead represents common fixed costs of the entire
company. If the outside supplier's offer were accepted, however, $18,000 of these allocated general
overhead costs would be avoided.

In addition, if the outside offer were accepted, the freed space could be used to produce part W28,
one of the company's other products, generating a total additional segment margin of $12,000 per
year for that product.

What would be the CHANGE IN the company's overall net operating income of BUYING part W28
from the outside supplier? Your answer should consist of “INCREASE” or “DECREASE” and an amount.

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 Decision Making Assignment #1 (Cont’d)
Pemulis Corporation makes 11,000 units of part W28 each year. This part is used in one of the
company's products. The company's Accounting Department reports the following costs of producing
the part at this level of activity:

An outside supplier has offered to make and sell the part to the company for $25.50 each. If this offer
is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided.
The special equipment used to make the part was purchased many years ago and has no salvage
value or other use. The allocated general overhead represents common fixed costs of the entire
company. If the outside supplier's offer were accepted, however, $18,000 of these allocated general
overhead costs would be avoided.

In addition, if the outside offer were accepted, the freed space could be used to produce part W28,
one of the company's other products, generating a total additional segment margin of $12,000 per
year for that product.
Make Buy
What would be the CHANGE IN the company's overall net operating income of BUYING part W28
from the outside supplier? Your answer should consist of “INCREASE” or “DECREASE” and an amount. Buy part $ 25.50
DM $ 6.00
DL $ 5.40
VOH $ 7.70
Sup Salary $ 4.20
Total per unit $ 23.30 $ 25.50
@11,000 units $ 256,300 $ 280,500
General OH Avoidable $ 18,000
Opportunity Costs $ 12,000
Total $ 286,300 $ 280,500
Increase in NOI $ 5,800

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 Decision Making Assignment #1 (Cont’d)

An automated turning machine is the current constraint at Greenleaf Corporation. Three products use
this constrained resource. Data concerning those products appear below:

List the products in order of their current profitability from most profitable first, to the least profitable
last. In other words, rank the products in the order in which they should be emphasized. Your answer will
simply be the product names, in order from most to least, such as “BG, DK, QU.”

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 Decision Making Assignment #1 (Cont’d)

An automated turning machine is the current constraint at Greenleaf Corporation. Three products use
this constrained resource. Data concerning those products appear below:

List the products in order of their current profitability from most profitable first, to the least profitable
last. In other words, rank the products in the order in which they should be emphasized. Your answer will
simply be the product names, in order from most to least, such as “BG, DK, QU.”

BG DK QU
Selling Price Per Unit $ 410.04 $ 255.84 $ 397.15
Variable Cost Per Unit 323.68 201.72 315.90
Contribution Margin Per Unit 86.36 54.12 81.25
Minutes on the Constraint 6.80 4.10 6.50
Contribution Margin Per Minute $ 12.70 $ 13.20 $ 12.50

Order of priority 2 1 3

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 Decision Making Assignment #1 (Cont’d)

Henri Martin manufactures part TE456 used in several of its engine models. Monthly production costs
for 1,000 units of TE4546 are as follows:

Direct materials $ 40,000

Direct labor 10,000
Variable overhead costs 30,000
Fixed overhead costs 20,000
Total costs $100,000

It is estimated that 10% of the fixed overhead costs assigned to TE456 will no longer be incurred if the
company purchases TE456 from the outside supplier. Henri Martin has the option of purchasing the
part from an outside supplier at $85 per unit.

If Henri Martin accepts the offer from the outside supplier, what is the total dollar amount of COSTS
that are relevant to the decision?

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 Decision Making Assignment #1 (Cont’d)

Henri Martin manufactures part TE456 used in several of its engine models. Monthly production costs
for 1,000 units of TE4546 are as follows:

Direct materials $ 40,000

Direct labor 10,000
Variable overhead costs 30,000
Fixed overhead costs 20,000
Total costs $100,000

It is estimated that 10% of the fixed overhead costs assigned to TE456 will no longer be incurred if the
company purchases TE456 from the outside supplier. Henri Martin has the option of purchasing the
part from an outside supplier at $85 per unit.

If Henri Martin accepts the offer from the outside supplier, what is the total dollar amount of COSTS
that are relevant to the decision?

DM $ 40,000
DL 10,000
VOH 30,000
Avoidable FC 2,000
Total Relevant Costs $ 82,000

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 TIME VALUE OF MONEY,
RETURN ON INVESTMENT &
INTEREST RATES

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 Building blocks
• Future value – what the investment is worth at time
=t
• Present value – what the investment is worth at
time = 0
• Number of periods – the number of (compounding)
periods, equal to t
• Payment amount – the amount of a constant
payment that is made in each period from one
investor to the other
• Discount rate – the opportunity cost of capital, the
‘interest rate’ the investment pays, the yield on the
bond or the IRR of the project
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 Why are PV and FV different
• The investor needs to be compensated for the
following:
• Expected inflation
• Default risk
• Delaying gratification

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 Future value
If I invest $5 for 1 year and I can earn 10% in
the market, what will my $5 be worth at t=1?

$5 principal + $.50 interest ($5 x 10%) = $5.50

Generalized as: FV = PV (1+r)N

*Note: Assumes reinvestment of the interest

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 Future value – year 2
• What about the next year (year 2)?
• Use: FV = PV (1+r)N

• PV = $5.50
• r = 10%
• N = 1 year

• FV = $6.05 = $5.50 x (1.10)1

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 Future value – N period model
• $5.00 grows to become $5.50, which grows to
become $6.05 over 2 periods
• FV = PV (1+r)N
• $6.05 = $5 x (1.10)2

• To move forward in time, multiply by (1+r) N

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 Quick Check
You have $10,000 and are considering 2 investment
options:
•Option A has a projected annual return of 4%
•Option B has a projected annual return of 6%

1.What is to projected future value of the investment at

the end of year 5 for each option?
Use: FV = PV (1+r)N
2.Which option is likely to encompass more risk?

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 Quick Check
1. What is to projected future value of the investment
at the end of year 5 for each option?
Option 1: FV = $10,000 (1+4%)5 = $12,166.53
Option 2: FV = $10,000 (1+6%)5 = $13,382.26

2. Which option is likely to encompass more risk?

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 Quick Check
1. What is to projected future value of the investment
at the end of year 5 for each option?
Option 1: FV = $10,000 (1+4%)5 = $12,166.53
Option 2: FV = $10,000 (1+6%)5 = $13,382.26

2. Which option is likely to encompass more risk?

Option 2 is likely to encompass more risk
The investor needs to be compensated for the following:
•Expected inflation
•Default risk
•Delaying gratification

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 Present value
• If I need to payoff my loan of $5 in 1 year,
how much do I need to invest today, assuming
I can earn 10%.
• FV = PV (1+r)N
• $5 = PV(1+10%)1
• PV = $5/(1.1)1
• PV = $4.55

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 Present value
• Why?
• $4.55 invested for 1 year at 10% earns $.45
over that time
• $4.55 principal + $.45 interest = $5.00

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 Changing interest rates
• What if I could only earn 6% instead of 10%?
• In order to have $5.00 to payoff my loan 1
year from today, how much do I need to
invest?

FV = PV (1+r)N

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 Changing interest rates
• What if I could only earn 6% instead of 10%?
• In order to have $5.00 to payoff my loan 1
year from today, how much do I need to
invest?
$5.00/(1+.06)1 = $4.72

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 Changing interest rates
• At 10%, I need to invest $4.55
• At 6%, I need to invest $4.72

• The PV and INT move in opposite directions

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 Present value – N period model
• In order to have $5 at the end of the loan, I
will need to have $4.55 one period before the
end of the loan
• In order to have $4.55 at time N-1, I will need
to invest $4.55/(1.10)1 = $4.14
• $4.14 x 1.1 = $4.55
• $4.55 x 1.1 = $5.00

• To move backward in time, divide by (1+r) N

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 Present Value vs Future Value

Time 0 1 2 3
$100.00

PV =
3
$100.00/(1+6%)
= $83.96

FV=
3
$83.96*(1+6%)
= $100.00

$100 in three years is worth $83.96 today if the interest rate = 6%

$83.96 today is worth $100 in 3 years if the interest rate is 6%

FV = PV (1+r)N PV = FV / (1+r)N

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 • What is the value of the interest free loan for a
full year to me?
• I could invest $4.55 of the $5.00 borrowed for
1 year, which would become $5.00 at the end
of the year, which I could use to payoff the
loan
• That would leave me with $.45 to consume
now, or invest for 1 period which would
become $.50 after 1 period.
• Free money for me
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 In Excel

A B C
1 CALCULATING FUTURE VALUES WITH EXCEL
2 Initial deposit 100
3 Interest rate 6%
4 Number of years, n 2
5
6 Account balance after n years 112.36 <-- =B2*(1+B3)^B4

USING FV FUNCTION

=FV[rate, nper, pmt, pv, type]

$112.36 =FV(.06,2,0,-100)

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 A B C D E F G
1 THE FUTURE VALUE OF A SINGLE $100 DEPOSIT
2 Initial deposit 100
3 Interest rate 11%
4
Future
5 Year value
6 0 100.00 <-- =$B$2*(1+$B$3)^A6
7 1 111.00 <-- =$B$2*(1+$B$3)^A7
8 2 123.21 <-- =$B$2*(1+$B$3)^A8
9 3 136.76 <-- =$B$2*(1+$B$3)^A9
10 4 151.81 <-- =$B$2*(1+$B$3)^A10
11 5 168.51
12 6 187.04 900
How the Future Value Grows at 11% Annual
13 7 207.62 Interest
800
14 8 230.45
700
15 9 255.80
600
16 10 283.94
500
17 11 315.18
Future value

18 12 349.85 400
19 13 388.33 300
20 14 431.04 200
21 15 478.46 100
22 16 531.09 0
23 17 589.51 0 5 10 15 20
24 18 654.36
Years
25 19 726.33
26 20 806.23

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 Future value at different interest rates

1000
900
800
700 FV at 0%
FV at 6%
600
FV at 12%
500
400
300
200
100
0
0 5 10 15 20

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 Accumulating Wealth
• Deposit your $10,000 signing bonus today
• Interest paid: 6% per year
• How much will you have to retire on at the
end of 30 years?
USING EXCEL FORMULA
FV=PV(1+RATE)^NPER

USING EXCEL FV FUNCTION

=FV(RATE, NPER, PMT, PV,[TYPE])

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 Accumulating wealth
• Deposit your $10,000 signing bonus today
• Interest paid: 6% per year
• How much will you have to retire on at the
end of 30 years?
• $57,435 = $10,000 x (1+.06) 30

FV = PV (1+r)N
USING EXCEL
$ 57,434.91 =10000*(1+.06)^30

USING FV FUNCTION
=FV[rate, nper, pmt, pv, type]
$57,434.91 =FV(.06,30,0,-10000)

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 Accumulating wealth
• If you waited until 10 years before you retire
to begin to invest, how much would you need
to deposit to equal the $57,435 computed
above, assuming 6% annual rate of return?
PV = FV / (1+r)N
USING EXCEL
?

USING PV FUNCTION
=PV(rate, nper, pmt, fv, type)

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 Accumulating wealth
• If you waited until 10 years before you retire
to begin to invest, how much would you need
to deposit to equal the $57,435 computed
above, assuming 6% annual rate of return?
PV = FV / (1+r)N

• $32,071 = $57,435 / (1+.06)10

USING EXCEL
$ 32,071.40 =57435/(1+.06)^10

USING PV FUNCTION
=PV(rate, nper, pmt, fv, type)
$ 32,071.40 =pv(.06,10,0,-57435)

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 Beginning vs end of year

Year 0 Year 1 Year 2

End of End of
Today year 1 year 2

Beginning Beginning Beginning

of year 1 of year 2 of year 3

0 1 2 3

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 Annuities
A B C D E F
FUTURE VALUE WITH ANNUAL DEPOSITS
1 at beginning of year
2 Interest 6%
3 =E5 =(C6+B6)*$B$2
Account Deposit at Interest Total in
balance, beginning earned account at
4 Year beg. year of year during year end of year
5 1 0.00 100.00 6.00 106.00 <-- =B5+C5+D5
6 2 106.00 100.00 12.36 218.36 <-- =B6+C6+D6
7 3 218.36 100.00 19.10 337.46
8 4 337.46 100.00 26.25 463.71
9 5 463.71 100.00 33.82 597.53
10 6 597.53 100.00 41.85 739.38
11 7 739.38 100.00 50.36 889.75
12 8 889.75 100.00 59.38 1,049.13
13 9 1,049.13 100.00 68.95 1,218.08
14 10 1,218.08 100.00 79.08 1,397.16
15
Future value
using Excel's
16 FV function $1,397.16 <-- =FV(B2,A14,-100,,1)

• Note: the payments are all equal, and evenly

spaced in time
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 Excel’s FV function
FV(rate, nper, pmt,[pv], [type])
Type: 0 =payment at end of period, 1
=payment made at beginning of period

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 Beginning vs end of period
Deposits at Beginning of Year

Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning End of
of year 1 of year 2 of year 3 of year 4 of year 5 of year 6 of year 7 of year 8 of year 9 of year 10 year 10

0 1 2 3 4 5 6 7 8 9 10

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

179.08 <-- =100*(1.06)^10

168.95 <-- =100*(1.06)^9
159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1

Total 1397.16 <-- Sum of the above

Deposits at End of Year

Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning End of
of year 1 of year 2 of year 3 of year 4 of year 5 of year 6 of year 7 of year 8 of year 9 of year 10 year 10

0 1 2 3 4 5 6 7 8 9 10

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

168.95 <-- =100*(1.06)^9

159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1
100.00 <-- =100*(1.06)^0

Total 1318.08 <-- Sum of the above

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 Present value of an annuity

A B C D
PRESENT VALUE OF AN ANNUITY: 5 future
1 FIVE ANNUAL PAYMENTS OF $100 EACH payments of
2 Annual payment 100
3 r, interest rate 6% $100 each,
4
Payment Present
interest rate
at end of value of 6%.
5 Year year payment
6 1 100 94.34 <-- =B6/(1+$B$3)^A6
7
8
2
3
100
100
89.00 <-- =B7/(1+$B$3)^A7
83.96
*Note: 3 ways
9 4 100 79.21 of getting the
10 5 100 74.73
11 present value
12 Present value of all payments
13 Summing the present values 421.24 <-- =SUM(C6:C10) (cells
14
15
Using Excel's PV function
Using Excel's NPV function
421.24 <-- =PV(B3,5,-B2)
421.24 <-- =NPV(B3,B6:B10)
C13:C15)

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 Excel’s PV function
• Computes present value of series of
constant payments (“annuity”)

A B C
1 EXCEL'S PV FUNCTION
2 Annual payment 100
3 Number of years 5
4 Interest rate 6%
5 Present value 421.24 <-- =PV(B4,B3,-B2)

• Note: match the sign to the direction of

the cash flows, negative (out flow),
positive (in flow)

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 PV function for an annuity due
• Previous slide shows PV for end-of-period
payments
• For beginning-of period, put Type = 1 in
PV dialog box

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 Excel’s NPV function
• Computes the present value (NOT net
present value!) of a series of payments
starting in period 1.
A B C D
1 CALCULATING PRESENT VALUES WITH EXCEL
2 r, interest rate 11%
3
Payment
at end of Present
4 Year year value
5 1 100 90.09 <-- =B5/(1+$B$2)^A5
6 2 200 162.32 <-- =B6/(1+$B$2)^A6
7 3 300 219.36
8 4 400 263.49
9 5 500 296.73
10
11 Present value of all payments
12 Summing the present values 1,031.99 <-- =SUM(C5:C9)
13 Using Excel's NPV function 1,031.99 <-- =NPV($B$2,B5:B9)

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 NPV has the wrong name!

• Later on we will encounter net present value

• Different concept from present value
• Excel’s NPV function computes the present
value . The name is wrong, but the function
performs the correct calculation.

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 Excel functions PV vs NPV
• Both compute present value
• Use PV to compute the present value of
an annuity stream—all the payments are
equal.
• Use NPV to compute the present value of
unequal payments over time.

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 Computing equal payments on a loan

• You borrow $10,000 for 5 years

• Interest rate 7%
• Bank wants same sum X repaid each year
• How to compute X?

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 Use PMT to compute loan payments

A B C
PMT TO COMPUTE FLAT LOAN
1 PAYMENTS
2 Interest rate 7%
3 Loan term 5 <-- Years
4 Loan principal 10,000
5 Annual flat payment 2,438.91 <-- =PMT(B2,B3,-B4)
6
7 Present value of payments = Loan principal
8 Year Payment
9 1 2,438.91 <-- =$B$5
10 2 2,438.91 <-- =$B$5
11 3 2,438.91 <-- =$B$5
12 4 2,438.91
13 5 2,438.91
14
15 PV of payments 10,000.00 <-- =NPV(B2,B9:B13)

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 Loan amortization table
• The “flat” loan payment pays off the loan
over the loan term:
A B C D E F

1
PMT AND LOAN AMORTIZATION TABLE
2 Interest rate 7%
3 Loan term 5 <-- Years
4 Loan principal 10,000
5 Annual flat payment 2,438.91 <-- =PMT(B2,B3,-B4)
6
7 Loan Amortization Table
Part of Part of
Principal,
Payment, payment payment
Year beginning
end of year that is that is
of year
8 interest principal
9 1 10,000.00 2,438.91 700.00 1,738.91 <-- =C9-D9
10 2 8,261.09 2,438.91 578.28 1,860.63
11 3 6,400.46 2,438.91 448.03 1,990.87
12 4 4,409.59 2,438.91 308.67 2,130.24
13 5 2,279.35 2,438.91 159.55 2,279.35
14
15 Cell B10 contains formula Cell D10 contains formula
16 =B9-E9 =$B$2*B10

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