Finance School of management Chapter 6. Capital Budgeting The basics Obiective Explain Capital Budgeting and Cost of Capital, Apply NPV Rule, and Develop Criteria of Evaluating Project STC
1 Finance School of Management Chapter 6. Capital Budgeting: The Basics Objective Explain Capital Budgeting and Cost of Capital, Apply NPV Rule, and Develop Criteria of Evaluating Project
Finance School of management Capital Budgeting Any capital budgeting process consists of three elements coming up with proposals for investment projects evaluating them deciding which ones to accept and which to reject uesTc
2 Finance School of Management Capital Budgeting u Any capital budgeting process consists of three elements: – coming up with proposals for investment projects – evaluating them – deciding which ones to accept and which to reject
Finance School of management The Nature of Project analysis Starting point: an idea for increasing shareholder wealth Procedures of project analysis Forecasting cash flows: decisions and events Flexibility of decisions in the projects uesTc
3 Finance School of Management The Nature of Project Analysis – Starting point: an idea for increasing shareholder wealth – Procedures of project analysis – Forecasting cash flows: decisions and events – Flexibility of decisions in the project’ s life
Finance School of management Objectives Investment projects fall into roughly three categories Whether to enter a new line of business Whether to invest in equipment to reduce costs Whether to replace an existing plant uesTc
4 Finance School of Management Objectives u Investment projects fall into roughly three categories: – Whether to enter a new line of business – Whether to invest in equipment to reduce costs – Whether to replace an existing plant
Finance School of management NPV Rule revisited Invest if the proposed project's NPv is positive Discount rate Opportunity cost: the rate of return on comparable Investment opportunities Cost of capital NPV: the fair market value in competitive and efficient market uesTc
5 Finance School of Management NPV Rule Revisited u Invest if the proposed project’s NPV is positive u Discount rate u Opportunity cost: the rate of return on comparable investment opportunities u Cost of capital u NPV: the fair market value in competitive and efficient market
Finance School of management NP∨ of a project Discout 10% Year OW PV Cum PV -1000 1000 1000 450 409 591 12345 350 289 302 250 188 -114 150 102 50 31 20 NP∨ 20 DCF Payback uesTc
6 Finance School of Management NPV of a Project Discout 10% Year Flow PV Cum_PV 0 -1000 -1000 -1000 1 450 409 -591 2 350 289 -302 3 250 188 -114 4 150 102 -11 5 50 31 20 NPV 20 DCF Payback
Finance School of management NPV of a project Discout 5% 15 Ye ear Flow PV Cum PV 1000 1000 1000 012345 450 391 609 350 265 344 250 164 -180 150 86 94 50 25 69 NP∨ 69 uesTc
7 Finance School of Management NPV of a Project Discout 15% Year Flow PV Cum_PV 0 -1000 -1000 -1000 1 450 391 -609 2 350 265 -344 3 250 164 -180 4 150 86 -94 5 50 25 -69 NPV -69
Finance School of Management <Internal Rate of Return) NPV of a Project Discout 11.04% Year Flow PV Cum PV 1000 1000-1000 012345 450 405 595 350 284 311 250 183 128 150 99 30 50 30 0 NP∨ 0 uesTc
8 Finance School of Management NPV of a Project Discout 11.04% Year Flow PV Cum_PV 0 -1000 -1000 -1000 1 450 405 -595 2 350 284 -311 3 250 183 -128 4 150 99 -30 5 50 30 0 NPV 0 Internal Rate of Return
Finance School of management NPV as a Function of discount rate 200 150 100 0 0 5% 10% 15% 20% 50 -100 150 -200 Tc Discount Rate
9 Finance School of Management NPV as a Function of Discount Rate -200 -150 -100 -50 0 50 100 150 200 250 0% 5% 10% 15% 20% Discount Rate NPV
Finance School of management Example: PC1000 of Compusell Corp Sales 4,000 units at a price of S5,000 s20,000,000 per ye Fixed Costs: Lease payments S1, 500,000 per year Property taxes 200,000 Administration 600,00o Advertising 500000 Other 300000 Total fixed costs s3,10O,0oo Varia ble costs. Direct labor $2,000 per unit Materials 1,o00 Selling expenses 5o0 Other 250 variable cost per unit $3,750 per unit Total Variable Costs for 4, 000 units s15,000,000per ea重 Forecast of initial Capital outlay for PC1000 Purchase of Equipment s2,800,000 Working Capital s2200000 Total Capital Outlay s5,000,000 Depreciation s4o0,000 Corporate Income Taxes 940%
10 Finance School of Management Example: PC1000 of Compusell Corp. Sales 4,000 units at a price of $5,000 $20,000,000 per year Fixed Costs: Lease payments $1,500,000 per year Property taxes 200,000 Administration 600,000 Advertising 500,000 Other 300,000 Total Fixed Costs $3,100,000 Variable Costs: Direct labor $2,000 per unit Materials 1,000 Selling expenses 500 Other 250 Variable cost per unit $3,750 per unit Total Variable Costs for 4,000 units $15,000,000 per year Forecast of Initial Capital Outlay for PC1000 Purchase of Equipment $2,800,000 Working Capital $2,200,000 Total Capital Outlay $5,000,000 Depreciation $400,000 Corporate Income Taxes @40%
