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## Capital Budgeting

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**Capital Budgeting**• Time value of money is a fundamental concept. If the interest rate in the economy is 10%, $1 today is worth $1.10 net year, $1.21 two years from today and $1.331 three years from today etc… • So, $1.10 next year $1.21 two years from now, $1.331 three years from now are all worth $1 today.**Capital Budgeting**• Now if I am to get $1.1 next year, $1.21 the year after and $1.331 the third year, what should I be willing to pay for the right to this stream of cash flows assuming that my only other alternative is to put the money in a bank account and get 10% interest? • Ans: $3, why? • Each year’s cash inflow is worth a dollar today.**Capital Budgeting**• If someone wants to sell me this investment for $2.90, my NPV (net present value) of the project is _____ • Ans: 10cents. How computed? • The cash inflows are worth $3 in today’s dollars, the outflows are $2.90 in today’s dollars, so the NPV (always in current dollars) is Cash Inflows – Cash Outflows = $0.10.**Capital Budgeting**• The basic equation of compound interest is shown on p. 96: PV(1+r)n = FV • (1+r)n is called the “factor” • To get the present value of a stream of cash inflows divide each future inflow amount by the factor for that year (this is called deflating the FV) and add all the deflated inflows … this is the formula on p.97.**Capital Budgeting**• To get the present value of a stream of cash outflows compute the sum of the deflated cash outflows. • To compute NPV of a project subtract PV(outflows) from PV(Inflows). • To do the computations by hand you can use special formulas for perpetuities and annuities. We will ignore this. • For this course, you should know how to do the computations using a financial calculator.**Capital Budgeting**• To correctly compute project NPV: • Use cash flows not accounting earnings. Remember to adjust for depreciation (and the tax consequences of depreciation) … see pp 110-11. • Exclude interest costs from relevant cash flows else you will be double-counting. • Include investment in working capital in funding requirements and discount the required additional investments at future points. • Include opportunity costs, ignore sunk costs.**Capital Budgeting**• Besides NPV, people also use • Payback period • Time taken to earn back the original investment (there is no discounting of any cash flows in this method). • This method may be useful when long-term cash flows are uncertain. However it can lead to serious mistakes in project selection since it ignores the “tail” of cash flows beyond the recovery of the initial amount. • In effect this method is very conservative and not a good first choice to use.**Capital Budgeting**• Other measures: • ROI (you know this) • IRR • The discount rate that makes the NPV of the project zero. You can compute this on any financial calculator. • There may be multiple IRRs for a single project, so this method can produce confusing answers. • IRR may be used to prioritize among projects when capital is limited: select projects with the highest IRR till you have used up all your capital. • However, this rule can be seriously misleading as well since it assumes that all cash inflows can be invested at the project’s internal rate of return which is an unrealistic assumption.**Capital Budgeting**• Moral: • Use NPV as the first step in evaluating projects. • If capital is in short supply, try and find the best mix of projects to take using simulation rather than use some arbitrary short-cuts (IRR etc.). • Look at payback period as a second step, especially if the projects are otherwise comparable (in magnitude of investment, life of cash flows). If strategic flexibility in the firm’s investment base matters, payback period is a healthy tool in spite of serious theoretical deficiencies. • In other words, be careful of using only NPV because cash flows in the far future are hard to predict.