Tutorial 2

Sessions 3 and 4
Capital Budgeting Decisions

Chara Kaffe
ck469@cam.ac.uk

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