DB11: Intro to Capital Budgeting - YouTube Please provide a summary of the highlights of the attached video

Capital Budgeting Basics DB

The video talked about the capital budgeting process and the project analysis techniques employed by companies. The video mentions the three different kinds of project criteria used to summarize a set of cash flows. He talks about the net present value (NPV), the internal rate of return (IRR) and the payback which are project analysis tools used to determine if a project is a winner or a loser. There are a few things which aren’t included in the analysis which include depreciation, sunk costs and financing flows. The presenter in the video showed an example and said to divide the cash flows into three categories: initial, project and terminal cash flows.

1. Definitions
   1. The net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used to analyze the profitability of a projected investment or project. A positive NPV means the project will create value while a negative NPV means the project won’t create value. NPV can be calculated on a calculator, but also on Excel’s own function.
   2. The internal rate of return (IRR) is the annual rate of growth an investment is expected to generate. It is the rate of return that will match the present value of the future cash flows to the initial investment. It is the average annual rate of return that the project’s cash flows are expected to throw off.
   3. Payback is the amount of time it takes to recover the cost of an investment or how long it takes for an investor to reach breakeven. Shorter paybacks are more attractive, while longer payback periods are less desirable. Pros of payback are it is simple, it measures liquidity and it is commonly used. Cons of payback are it doesn’t consider the required rate of return and it doesn’t consider the cash flows beyond payback years.

2. NPV uses discounted cash flows in the analysis which makes it the most precise of the three methods since it considers both the risk and time variables. It shows how profitable a project will be versus alternatives. For IRR, if the rate is higher than the cost of capital, it is a good project. The payback determines how long it would take a company to see enough in cash flows to recover the original investment. These three are important in capital budgeting since they are the three common approaches to a project selection and determine the value of a potential investment project.

Intro to Capital Budgeting Video Notes

• Payback Pros: simple, good measure of liquidity, common
• Payback Cons: there is no benchmark to determine whether the number is good or bad, doesn’t considered the required rate of return, doesn’t consider the cash flows beyond payback years.
• Net Present Value: positive means the project creates value and negative means it won’t.
• IRR is the rate of return that will match the present value of the future cash flows to the initial investment; the average annual rate of return that the project’s cash flows are expected to throw off.
• Payback: 2.3 years [seems ok but not sure]
• NPV: $12,627 [value creation is expected to be positive]
• IRR: 16.1% [project’s expected return is greater than the 12% cost]
• Cash flows that are mapped out explicitly:
  • Costs to get the project going (outflows)
  • Additional revenue (inflows)
  • Increases in costs (outflows)
  • Reduction in costs (inflows)
  • Opportunity costs (outflows)
  • Erosion or cannibalization (outflows)
  • Increases or decreases to working capital (inflows or outflows)
  • Taxes (inflows or outflows)
• Some things that are not considered in the analysis:
  • Depreciation
    • It is a non-cash expense so is not included, but we must consider the tax impact of depreciation.
  • Sunk Costs
    • This cash is already gone so the key question is what do we do now to improve our situation or minimize total losses?
  • Financing Flows
    • They are considered as part of the discount rate, so we don’t want to double count them.
• Ex:
  • You are considering a new product. Machinery and equipment will cost $60,000 if bought today and it will be depreciated straight line to zero over the next three years. In addition, you will require working capital of $15,000 immediately to get the product to market next year. The new product is expected to generate revenue of $100,000 per year for 3 years. Project operating costs will be $40,000 per year. At the end of the three years, you will recover your initial working capital. Taxes will be 40% and the project’s risk level is specified to be high and thus you assign a required return of 11% to it.
    
     
  • To get the project up and running ASAP, you need:
    • $60,000 to buy the machinery and equipment
    • $15,000 in new working capital (for example, to secure raw materials to produce the product.
    • Total Initial Cash Flow Investment: $75,000
  • For each of the three years, you forecast cash flows to be:
    • Sales: $100,000
    • Costs: (40,000)
    • Depr: (20,000)
    • Project Margin: 40,000
    • Taxes: (16,000)
    • Project Income: $24,000
    • Depr: 20,000
    • Annual Project Cash Flow: $44,000
  • At the end of the project’s life, we presume the project is unwound which has a number of possible cash flow impacts:
    • Recovery of net-working capital: $15,000
    • Sale of machinery and equipment: $0?
      • Total Terminal Flows: $15,000
    • If inventory goes down, cash flow goes up and vice versa
    •