Capital Budgeting
Capital budgeting
Capital budgeting describes the long-term longplanning for making and financing major long-term projects. long-
CAPITAL BUDGETING
1. Identify potential investments. 2. Choose an investment.
3. Follow-up or “post audit.” Follow“post audit.”
Net present value model
Net present value model
The net-present-value (NPV) method net-presentcomputes the present value of all expected future cash flows using a minimum desired rate of return.
The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate.
The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.
Applying the NPV method
NPV example
Original investment (cash outflow): $5,827
Prepare a diagram of relevant expected cash inflows and outflows.
Useful life: four years
Find the present value of each expected cash inflow or outflow.
Annual income generated from investment (cash inflow): $2,000
Sum the individual present values.
Minimum desired rate of return: 10%
1
NPV example
Present Value of $1 Total Discounted Present At 10% Value Discounting Cash Flows .9091 .8264 .7513 .6830 $1,818 1,653 1,503 1,366
NPV example
0
Sketch of Cash Flows at End of Year 1 2 3
4
Approach 2: Using an Annuity Table Sketch of Cash Flows at End of Year 0 1 2 3 4 3.1699 $6,340 $2,000 $2,000 $2,000 $2,000 1.0000 (5,827) $(5,827) $ 513
Approach 1: Cash flows Annual savings
2,000 2,000 2,000 2,000
Annual Savings Initial Outlay Net present value
Present value of Future inflows Initial Outlay 1.0000 Net present value
$6,340 (5,827) $(5,827) $ 513
Assumptions of the NPV model
Decision rules
Managers determine the sum of the present values of all expected cash flows from the project.
There is a world of certainty.
Predicted cash flows occur timely.
If the sum of the present values is
Capital budgeting describes the long-term longplanning for making and financing major long-term projects. long-
CAPITAL BUDGETING
1. Identify potential investments. 2. Choose an investment.
3. Follow-up or “post audit.” Follow“post audit.”
Net present value model
Net present value model
The net-present-value (NPV) method net-presentcomputes the present value of all expected future cash flows using a minimum desired rate of return.
The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate.
The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.
Applying the NPV method
NPV example
Original investment (cash outflow): $5,827
Prepare a diagram of relevant expected cash inflows and outflows.
Useful life: four years
Find the present value of each expected cash inflow or outflow.
Annual income generated from investment (cash inflow): $2,000
Sum the individual present values.
Minimum desired rate of return: 10%
1
NPV example
Present Value of $1 Total Discounted Present At 10% Value Discounting Cash Flows .9091 .8264 .7513 .6830 $1,818 1,653 1,503 1,366
NPV example
0
Sketch of Cash Flows at End of Year 1 2 3
4
Approach 2: Using an Annuity Table Sketch of Cash Flows at End of Year 0 1 2 3 4 3.1699 $6,340 $2,000 $2,000 $2,000 $2,000 1.0000 (5,827) $(5,827) $ 513
Approach 1: Cash flows Annual savings
2,000 2,000 2,000 2,000
Annual Savings Initial Outlay Net present value
Present value of Future inflows Initial Outlay 1.0000 Net present value
$6,340 (5,827) $(5,827) $ 513
Assumptions of the NPV model
Decision rules
Managers determine the sum of the present values of all expected cash flows from the project.
There is a world of certainty.
Predicted cash flows occur timely.
If the sum of the present values is