Capital Budgeting Chapter 5 in RWJJ – Capital Budgeting the process of choosing the best investment projects. – Because trial capital budgeting techniques are either rarely used in practice or are inefficient, we will only concern ourselves with Net Present Value and IRR - Net Present Value - Present value of a project’s future cash flows NPV Cost of Capital The appropriate discount rate The required rate of return The rate of return given up by investing in a project The risk-adjusted rate of return The rate of return investors could earn on an investment of equal risk How to Make a Capital Budgeting Decision 1. Forecast the project’s incremental free cash flow in each future time period 2. Determine the correct cost of capital to use 3. Discount all incremental free cash flows to time zero at the cost of capital 4. Net out all time zero cash flows not paid or received yet - that’s your NPV 5. If NPV > 0, accept the project If NPV < 0, reject the project Rule of Thumb: Accept all positive NPV projects because they give shareholders more than their required rate of return. Example: Cost: $100,000 at time zero Free Cash Flow: $25,000 - first year $30,000/yr. for the next 4 All cash flow projections are certainties. The alternative is to invest in a 5-year Treasury Note yielding 6% -100 25 30 30 30 30 0 1 2 3 4 5 NPV = -$100,000 + 25,000 + 30,000 + 30,000 + 30,000 + 30,000 1.06 (1.06)2 (1.06)3 (1.06)4 (1.06)5 = -$100,000 + 23,585 + 26,700 + 25,189 + 23,763 + 22,418 = -$100,000 + $121,653.93 = +$21,653.93 Accept the project. It increases the (present) value of the company by $21,653.93
Capital Budgeting – Chapter 5 in RWJJ Capital Budgeting – the process of choosing the best investment projects. Because capital budgeting techniques are either rarely used in practice or are inefficient, we will only concern ourselves with Net Present Value and IRR NPV - Net Present Value - Present value of a project’s future cash flows Cost of Capital The appropriate discount rate The required rate of return The rate of return given up by investing in a project The risk-adjusted rate of return The rate of return investors could earn on an investment of equal risk How to Make a Capital Budgeting Decision 1. Forecast the project’s incremental free cash flow in each future time period 2. Determine the correct cost of capital to use 3. Discount all incremental free cash flows to time zero at the cost of capital 4. Net out all time zero cash flows not paid or received yet - that’s your NPV 5. If NPV > 0, accept the project If NPV < 0, reject the project Rule of Thumb: Accept all positive NPV projects because they give shareholders more than their required rate of return. Example: Cost: $100,000 at time zero Free Cash Flow: $25,000 - first year $30,000/yr. for the next 4 All cash flow projections are certainties. The alternative is to invest in a 5-year Treasury Note yielding 6% -100 25 30 30 30 30 0 1 2 3 4 5 NPV = -$100,000 + 25,000 + 30,000 + 30,000 + 30,000 + 30,000 1.06 (1.06)2 (1.06)3 (1.06)4 (1.06)5 = -$100,000 + 23,585 + 26,700 + 25,189 + 23,763 + 22,418 = -$100,000 + $121,653.93 = +$21,653.93 Accept the project. It increases the (present) value of the company by $21,653.93 trial