Introduction to Capital Budgeting
1. Introduction to Capital Budgeting
Welcome back! In this chapter, we will review capital budgeting concepts.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. Because companies have limited budgets, most projects are mutually exclusive, which means they can only choose one, so companies must prioritize the most profitable projects first.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 present value cash flows of a project. If NPV is greater than 0, then the company should invest. Let's look at an example.4. Net present value (NPV)
Should a company invest in this project? In time zero, the upfront investment is $50,000. Then it generates $20,000 each year between years one and four.5. Net present value (NPV)
First, we should calculate the present value for each cash flow using the 10% discount rate.6. Net present value (NPV)
Then we sum the present values to get NPV. Since NPV is positive, the company should invest.7. Where do discount rates come from?
Now it's time that we had a talk... the talk: where do discount rates come from? Remember that present value calculations discount the future value of money to a lesser amount. For this reason the rates used in these calculations are called "discount rates". 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 return on stocks or other investments could be used. The cost of capital is the cost of raising money for the project, which is usually the combined cost of issuing debt and equity.8. Discount rates and NPV
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. This makes sense because if the cost of capital increases,the project would return less.9. The internal rate of return
The internal rate of return, or IRR, is the discount rate at which NPV equals zero. IRR is the rate of return for the project's cash flows. This makes sense logically. Since the discount rate represents the project's cost, there would be no real financial gain if the project's cost is equal to its return.10. Testing the IRR
The best way to illustrate this is to solve for NPV using the IRR as the discount rate. Let's say that we ran this cash flow through the IRR function in Excel, and it gave us 21.86%. What happens if we plug this into our NPV formula?11. Testing the IRR
First we find all the present values of the cash flows.12. Testing the IRR
Then we add them all together and find that NPV equals zero. Exactly what we expected. If the discount rate is equal to the return of the project, NPV will equal zero.13. Using IRR in capital budgeting
IRR is a popular metric because it gives a discounted rate of return for a project and can be easily compared against other projects. When comparing IRR against two projects, the project with the higher IRR should be selected. Other times, companies will compare the IRR of a project against a benchmark rate of return. If IRR is higher than the benchmark, then the project should be selected.14. The Golden Rule
Many companies have their unique preferences and methodologies. However, the golden rule of capital budgeting is to select the project with the highest positive NPV, regardless of the IRR. This is because NPV represents a real dollar amount. What good would a project be if it had a 100% internal rate of return but only generated $5?15. Let's practice!
Alright, that was a lot of information. Let's put it to use with some practice!Create Your Free Account
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