Capital Budgeting Techniques

Overview

• Discussion on main capital budgeting techniques:
  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)
  • Payback Period
• Practical exercises using Excel

Capital Budgeting

• Definition: Process a company uses to decide whether to accept or reject a project.
• Typical Projects: Large investments like building factories, opening stores, creating new products.
• Conducted By: Financial Planning and Analysis team.
• Goal: Maximize profitability and enhance shareholder value.

Net Present Value (NPV)

• Definition: Tells us how valuable a project is going to be.
• Rule: Accept project if NPV > 0.
• Project Prioritization: If multiple projects have positive NPV but limited funds, prioritize those with highest NPV.
• Example:
  • Nike's Financial Planning team evaluates two new stores.
  • Cash inflows and outflows assessed.
  • Initial outflows: acquiring property, renovations, etc.
  • Calculate Net Cash Flow: Sum of cash inflows and outflows.
  • Time Value of Money: Discount future cash flows to present value using a discount rate (e.g., 8%).
  • Formula: =NPV(rate, values) + year 0 net cash flow
  • Interpretation: Positive NPV = project adds value and should be pursued.

Limitations of NPV

• Project Size: Larger projects tend to have higher NPV, doesn't account for scale.
• Discount Rate: Assumptions can vary NPV significantly.

Internal Rate of Return (IRR)

• Definition: Discount rate that results in NPV of 0.
• Rule: Accept project if IRR > cost of capital.
• Example:
  • =IRR(values) function in Excel.
  • Comparison: Higher NPV vs. higher IRR.
  • Mutually Exclusive Projects: Prioritize higher NPV for maximum shareholder value.

Limitations of IRR

• Dollar Value: Does not provide a dollar value of the project.
• Non-Linear Cash Flows: Assumes linear cash flows, which may not always be the case.

Payback Period

• Definition: Time it takes for a company to recover its initial investment.
• Calculation:
  • Cumulative Cash Flow: Sum of net cash flows over time.
  • Manual Calculation: Identify the year when cumulative cash flow turns positive.
  • Example: 3.91 years for payback.
• Reformatting: Custom number format for clarity (e.g., 3.91 years).

Limitations of Payback Period

• Time Value of Money: Does not account for it.
• Discounted Payback Period: Adjusts for time value by discounting cash flows first.
• Focus: Only on recovery of investment, not profits or returns.

Summary

• Use these techniques for project evaluation.
• For mutually exclusive projects, prioritize based on NPV.
• Resources: Additional courses on finance and valuation available.

Conclusion

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• Check out related videos and courses for deeper understanding.
• Comment for any questions.