1. Capital Budgeting
Welcome back to Financial Analysis in Power BI! In this lesson, we will review concepts in capital budgeting, net present value, and discount rates.
2. What is capital budgeting?
Capital is another word for money. So capital budgeting is the process of allocating money to new projects that generate cash flows.
Analysts will estimate those cash flows using forecasts and details about the project. From there, a recommendation can be made on whether or not to invest.
Because companies have limited budgets, most projects are mutually exclusive, which means they can only choose one.
So how would they decide?
3. Net present value (NPV)
Net present value is one of the most reliable tools for making investment decisions. It is the sum of all discounted cash flows of a project.
As you may have noticed, the formula is just a series of present-value calculations summed together.
If NPV is less than zero, don't undertake the project. This is because the project would yield a negative return, and the company would be better off investing it elsewhere.
Let's look at an example.
4. Net present value (NPV)
Should a company invest in this project at a 10% discount rate?
Notice that in time zero, the upfront investment is listed at 50,000 dollars. Then it generates 20,000 dollars between years one and four.
5. Net present value (NPV)
The first thing we should do is calculate the present value for each cash flow, using t as the number of years to discount.
6. Net present value (NPV)
Once we have our present values, we simply sum them up at the end.
Since NPV is positive, the company should invest into this project.
7. Discount rates and NPV
Now it's time that we had a talk... the talk.
Discount rates are super important in time value of money calculations, especially in net present value.
This graph, known as an "NPV Profile", shows how the net present value changes as the discount rate changes. The net present value eventually becomes negative at a high enough discount rate.
Because of this relationship between the discount rate and net present value, analysts must select the right rate for the project.
8. Where do discount rates come from...
The two most common sources of discount rates are opportunity costs and costs of capital.
Opportunity cost is the next best alternative return given up to pursue the selected project. For example, the yields of bonds, stocks, or other investments could be used as the discount rate in the analysis.
The cost of capital is the cost of raising money for the project, usually by issuing debt and/or equity in the form of stocks.
The weighted average cost of capital, or WACC, is the weighted average cost of debt and equity, and it is one of the most popular discount rates as companies try to beat the cost it took them to raise funds for the project.
While finding WACC is outside the scope of this course, it's important you're familiar with the term.
9. Profitability index (PI)
The profitability index is another useful tool in capital budgeting.
It turns NPV into a ratio and tells the analyst how efficiently the project generates a dollar for every dollar spent. Therefore, it is used to prioritize projects when capital is limited.
The higher the ratio, the better return per dollar. Anything less than one should not be undertaken, as this would imply a negative NPV.
If we took the numbers from the last example, we'd find that the project would have a profitability index of 1 point 27.
10. Choosing the right project
So how does a company pick between two mutually exclusive projects? It depends!
The golden rule of capital budgeting is to select the project with the highest net present value because NPV represents a real dollar amount. If a company can only choose one project, then they should pick the project that will generate the most cash.
NPV has it's limitations. The first being that cash flows are estimates, so it's not guaranteed. Second, NPV does not consider qualitative risks or business objectives.
So while NPV is one of the best tools, analysts can use other metrics to prioritize projects depending on the business need.
11. Let's practice!
Okay, that was a lot of information. Let's take some time to practice.