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Tutorial 2 Sessions 3 and 4 Capital Budgeting Decisions: Chara Kaffe Ck469@cam - Ac.uk

This document discusses capital budgeting decisions and techniques for evaluating investment projects. It covers estimating cash flows, calculating net present value (NPV), determining internal rate of return (IRR), and other methods like payback period and profitability index. Formulas are also presented for aftertax salvage value, variable costs, operating cash flow, and total cash flow. The document provides an overview of key concepts and methods for capital budgeting analysis and decision making.

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70 views6 pages

Tutorial 2 Sessions 3 and 4 Capital Budgeting Decisions: Chara Kaffe Ck469@cam - Ac.uk

This document discusses capital budgeting decisions and techniques for evaluating investment projects. It covers estimating cash flows, calculating net present value (NPV), determining internal rate of return (IRR), and other methods like payback period and profitability index. Formulas are also presented for aftertax salvage value, variable costs, operating cash flow, and total cash flow. The document provides an overview of key concepts and methods for capital budgeting analysis and decision making.

Uploaded by

michellekhc
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Tutorial 2

Sessions 3 and 4
Capital Budgeting Decisions

Chara Kaffe
[email protected]

C. Kaffe (JBS) MM6: Finance Tutorial 2


Estimating Cash Flows

Sales
- COGs (Cost of goods sold)
- SG&A (Selling, general and administrative expenses)
- Depreciation
= EBIT (Earnings Before Interest and Tax)
- Taxes
= Net Income (NI)
+ Depreciation
= Operating Cash Flow (OCF)

Operating Cash Flow (OCF)


- Change in Net Working Capital (NWC)
- Net Capital Spending
= Total Cash Flow (FCF)
Your FCFs are ready each year to calculate the NPV – discount them to today!
C. Kaffe (JBS) MM6: Finance Tutorial 2
Net Present Value (NPV)

• Discounted cash flow (inflows and outflows)


• Fundamental technique to assess investments
• An investment has an initial cost, period flows and end flow

𝑁𝑃𝑉 = −𝐶𝑜𝑠𝑡 + 𝑃𝑉
Where PV is
𝐶1 𝐶2 𝐶3 𝐶𝑇
PV = 1+𝑟 1
+
1+𝑟 2
+
1+𝑟 3
+ ⋯+
1+𝑟 𝑇

• If NPV > 0, the project should be undertaken. If the NPV<0, the project should not
be undertaken
• Choose project with highest NPV

C. Kaffe (JBS) MM6: Finance Tutorial 2


Internal Rate of Return (IRR)
• Internal Rate of Return (IRR) = the discount rate that sets NPV = 0

𝐶1 𝐶2 𝐶3 𝐶𝑇
0 = −𝐶𝑜𝑠𝑡 + 1+𝐼𝑅𝑅 1
+ 1+𝐼𝑅𝑅 2
+ 1+𝐼𝑅𝑅 3
+ ⋯+ 1+𝐼𝑅𝑅 𝑇

– Accept if IRR exceeds the required return


– Accept the project with the highest IRR

• However: IRR can be flawed

• NPV and IRR will generally give the same decision EXCEPT:
– Non-conventional cash flows (signs change more than once)
– Mutually exclusive projects

C. Kaffe (JBS) MM6: Finance Tutorial 2


Other Methods

• Payback Period = number of years to recover initial costs


– Create cumulative Cash Flows for every year and see when they hit zero

• Average Accounting Return


𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝐴𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

– Accept if AAR exceeds a threshold

• Profitability Index (PI)

𝑇𝑜𝑡𝑎𝑙 𝑃𝑉 𝑜𝑓 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠


𝑃𝐼 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

– Accept if PI > 1
– Select projects with highest PI

C. Kaffe (JBS) MM6: Finance Tutorial 2


Formulas

• Aftertax Salvage Value


• If MV > BV: Net Cash Flow from Salvage Value = MV - (MV-BV) x Corporate Tax Rate
• If MV < BV: Net Cash Flow from Salvage Value = MV + (BV - MV) x Corporate Tax Rate

• Variable costs = Unit Cost * Number of Units Produced

• Operating Cash Flow (OCF) = Net Income + Depreciation

Total Cash Flow (FCF) = Operating Cash Flow


– Net Capital Spending
– Change in NWC

C. Kaffe (JBS) MM6: Finance Tutorial 2

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