Introduction to Capital Budgeting
Summary
TLDRThe video script offers an in-depth exploration of capital budgeting, a crucial process for companies when making strategic, long-term investments. It explains the importance of considering the time value of money and the concept of discounting cash flows. The script delves into various techniques such as the payback method, net present value (NPV), and internal rate of return (IRR) to evaluate investment feasibility and compare alternatives. It also discusses the selection of appropriate discount rates, including the cost of debt, cost of equity, and the weighted average cost of capital (WACC), and how these rates reflect a company's risk profile and the financing mix of a project. The video emphasizes the need for accurate forecasting of cash flows, revenues, costs, and the impact of balance sheet items on liquidity. It concludes with the significance of estimating the terminal value of assets and the release of working capital at the project's end, rounding out the comprehensive approach to capital budgeting for strategic decision-making.
Takeaways
- 💼 **Capital Budgeting Definition**: It's the process companies use to decide on long-term investments and strategic decisions, such as new production plants or R&D activities.
- 📈 **Time Value of Money**: The principle that a dollar today is worth more than a dollar in the future due to its potential earning capacity.
- 💹 **Discounting Cash Flows**: A technique to find the present value of future cash flows, which is crucial for evaluating investments.
- 🔍 **Investment Evaluation**: Capital budgeting helps answer if an investment makes sense and if it's the best alternative by using techniques like NPV and IRR.
- 🏦 **Discount Rates**: Companies use various rates like cost of debt, cost of equity, or a hurdle rate to measure the desired rate of return and account for risk.
- 📊 **Cost of Capital**: Includes the cost of equity, cost of debt, and the weighted average cost of capital (WACC), which are used to evaluate investment opportunities.
- 🛠️ **Project Cash Flows**: Includes initial investment, working capital needs, sale of old assets, operating cash flows, and residual value at the end of the project's life.
- 🔮 **Forecasting Cash Flows**: Involves estimating revenues, costs, and other balance sheet impacts to project future cash flows for the life of the investment.
- 🛑 **Irreversibility**: Capital budgeting decisions are often irreversible, meaning once made, they can significantly impact the company for years.
- 📉 **Risk Consideration**: The discount rate should reflect the risk associated with the project, which can differ from the company's overall risk profile.
- 🔗 **Leverage Impact**: A project's capital structure can affect its risk profile, necessitating adjustments to the company's beta when assessing the project.
Q & A
What is capital budgeting and why is it important for companies?
-Capital budgeting, also known as capital asset planning, is the decision-making process companies go through to determine whether to invest in a specific long-term initiative or asset. It is important because it allows company executives to compare alternatives and make strategic decisions that will shape the company's success in the years to come.
What are the two fundamental notions introduced in the script that are essential for understanding capital budgeting?
-The two fundamental notions introduced are the time value of money and discounting cash flows. These concepts are crucial for evaluating the worth of future cash flows in today's terms, which is a core part of capital budgeting.
How does the time value of money principle affect the decision-making process in capital budgeting?
-The time value of money principle states that money available today has more potential earning capacity than the same amount in the future. This principle affects decision-making by emphasizing the preference for receiving money sooner rather than later, and it is used to discount future cash flows to their present value for comparison purposes.
What are the typical discount rates used by companies to measure a desired rate of return and account for risk?
-Typical discount rates used by companies include the firm's cost of debt, the firm's cost of equity, the weighted average cost of capital (WACC), and a hurdle rate chosen by management. These rates are used to discount future cash flows and determine the viability and attractiveness of investment opportunities.
What is the Capital Asset Pricing Model (CAPM) and how is it used in capital budgeting?
-The Capital Asset Pricing Model (CAPM) is a model used to calculate a company's cost of equity by adding the risk-free rate to the product of the company's beta and the market risk premium. It is used in capital budgeting to determine the required return on equity investments and to serve as a discount rate for cash flows when the project is financed entirely with equity.
How does the Weighted Average Cost of Capital (WACC) differ from other discount rates?
-The Weighted Average Cost of Capital (WACC) is a discount rate that considers both the cost of debt and the cost of equity, weighted by the proportion of debt and equity used to finance the project. It provides a blended cost of capital that reflects the average opportunity cost of investment for both debt and equity investors, making it suitable for projects financed with a mix of debt and equity.
What are the typical cash flows involved in a capital budgeting exercise?
-Typical cash flows in a capital budgeting exercise include the initial capital outlay, working capital requirements, potential sales of old assets, recurring operating cash flows from the project's operations, and terminal cash flows from the sale of residual assets and the release of working capital at the end of the project's life.
Why is it necessary to forecast revenues and expenses for a capital budgeting project?
-Forecasting revenues and expenses is necessary to estimate the cash inflows and outflows throughout the project's life. This helps in determining the project's financial viability, expected rate of return, and its ability to generate sufficient cash to cover costs and provide a return on investment.
How can a company estimate the terminal value of an asset at the end of a project's life?
-A company can estimate the terminal value of an asset by considering its degree of obsolescence and consulting with specialized personnel who can assess the asset's remaining value. Terminal values can vary widely depending on the type of asset and its expected condition at the end of its useful life.
What is the significance of working capital in the context of capital budgeting?
-Working capital, which includes inventory, trade receivables, and trade payables, represents cash that is tied up in the day-to-day operations of the project. It is significant because it needs to be invested at the beginning of the project and is typically released at the end of the project's life, impacting the overall cash flows.
Why is it important to consider the cost of debt and the cost of equity when evaluating a project that uses both types of financing?
-It is important because the cost of debt and the cost of equity represent the costs associated with different sources of financing. Using a single discount rate that does not reflect the mix of financing would lead to an inaccurate valuation of the project. The WACC, which combines these costs, provides a more accurate discount rate for such projects.
How does the concept of 'beta' relate to the cost of equity and why is it important?
-Beta is a measure of a stock's volatility in relation to the overall market. It is used in the CAPM to adjust the cost of equity for the specific risk of the company's stock. A higher beta indicates a riskier stock, which would command a higher expected return, thus affecting the cost of equity and the company's overall cost of capital.
Outlines
💼 Introduction to Capital Budgeting and Its Importance
The first paragraph introduces the concept of capital budgeting, which is the process companies use to make strategic decisions about long-term investments. It emphasizes the significance of capital budgeting in shaping a company's future success and the importance of considering the time value of money and discounting cash flows. The paragraph also outlines the key questions capital budgeting aims to answer: whether an investment is sensible and if it's the best alternative available. It mentions various techniques such as the payback method, net present value (NPV), and internal rate of return (IRR), and discusses how companies consider the risk and time value of money when determining a desired rate of return.
📊 Time Value of Money and Discounting Cash Flows
The second paragraph delves into the principles of the time value of money and how it impacts financial decisions. It explains the concept of discounting future cash flows to their present value using an interest rate, which compensates for the time the money is invested. The paragraph illustrates the process of calculating present and future values with examples, highlighting the importance of using the correct discount rate and considering the timing of cash flows. It also touches on the selection of the discount rate and its role in evaluating investment opportunities.
🏦 Understanding Discount Rates in Capital Budgeting
The third paragraph discusses the different discount rates that can be used in capital budgeting, such as the firm's cost of debt, cost of equity, weighted average cost of capital (WACC), or a hurdle rate. It explains the cost of debt as the interest rate paid on borrowings and how it's used when a project is financed entirely with debt. The paragraph also covers the cost of equity, calculated using the Capital Asset Pricing Model (CAPM), which includes the risk-free rate, beta, and market risk premium. It further explains how to adjust a company's beta for a specific project's risk profile and leverage, and how to calculate the WACC, which considers both debt and equity financing.
🔄 Capital Budgeting Techniques and Cash Flow Sequence
The fourth paragraph continues the discussion on capital budgeting by describing the sequence of cash flows expected in a capital budgeting exercise. It outlines the initial investment, working capital requirements, potential sale of old assets, recurring operating cash flows, and the residual value of the investment at the end of the project's life. The paragraph also highlights the importance of forecasting these cash flows and the need to consider various factors such as demand, pricing, and costs when estimating revenues and expenses.
🛠️ Forecasting Cash Flows and Project Assessment
The fifth paragraph focuses on the process of forecasting the cash flows associated with a capital budgeting project. It emphasizes the need to estimate the initial investment, working capital, and the impact of balance sheet items on cash flows. The paragraph discusses the challenges of predicting revenues and expenses, suggesting that costs of goods sold (COGS) and operating expenses (OPEX) are often modeled as a percentage of revenue. It also addresses the estimation of terminal asset values and the release of working capital at the project's end, which are crucial for a comprehensive capital budgeting analysis.
📈 Capital Budgeting: Estimating Revenues, Costs, and Terminal Values
The sixth and final paragraph wraps up the discussion by emphasizing the importance of estimating revenues, costs, and terminal values in capital budgeting. It stresses the complexity of predicting the demand for products and the prices at which they will be sold over the project's lifespan. The paragraph also highlights the need to consider the potential changes in the prices of components, labor costs, and other unforeseen factors when estimating expenses. It concludes by noting the significance of these estimations in performing a proper capital budgeting exercise to assess the financial viability of the project.
Mindmap
Keywords
💡Capital Budgeting
💡Time Value of Money
💡Discounted Cash Flows (DCF)
💡Net Present Value (NPV)
💡Internal Rate of Return (IRR)
💡Discount Rate
💡Cost of Equity
💡Cost of Debt
💡Weighted Average Cost of Capital (WACC)
💡Sensitivity Analysis
💡Terminal Value
Highlights
Capital budgeting is a decision-making process used by companies to determine whether to invest in long-term initiatives or assets.
It allows executives to compare different strategic alternatives and assess the feasibility of investments.
The time value of money and discounting cash flows are fundamental concepts in capital budgeting.
Investments are assessed based on whether they create or destroy value and if they are the best alternative available.
Payback method, NPV (Net Present Value), and IRR (Internal Rate of Return) are key techniques in capital budgeting.
Discount rates used in capital budgeting can include the firm's cost of debt, cost of equity, or a hurdle rate set by management.
The Capital Asset Pricing Model (CAPM) is used to calculate a company's cost of equity.
Beta is a statistical measure representing the volatility of a stock relative to the market.
The Weighted Average Cost of Capital (WACC) is used when a project is financed with a mix of debt and equity.
Forecasting involves estimating revenues, costs, and working capital needs to simulate the project's financials.
Sensitivity analysis helps assess how changes in investment costs or other variables can impact the project's financials.
Deferred taxes can affect cash flow estimations and should be considered in certain cases.
The terminal value of an asset at the end of a project's life is determined by its obsolescence and potential resale value.
Working capital is an important factor, as the amount tied up in the project will be freed up at the project's end.
Capital budgeting provides a quantitative means to compare different investment alternatives and select the most viable option.
The process involves a comprehensive analysis of the project's initial investment, timing, and expected returns.
Practical applications of capital budgeting include investment in new production plants, ERP systems, R&D activities, and employee training.
The importance of considering the time value of money is emphasized, as it affects the calculation of present and future cash flows.
Transcripts
we will explain what capital budgeting
is and why companies use it when making
strategic decisions then we will
continue by introducing two fundamental
notions for those of you who need a
quick refresher the time value of money
and discounting cash flows once we have
covered these topics we will be ready to
introduce a few techniques that allow us
to answer the two most important
questions in capital budgeting does the
investment make sense and is this the
best alternative we have will study the
payback method with the NPV and IRR
techniques then we'll talk about the
typical discount rates companies use to
measure a desired rate of return and
account for risk and the time value of
money we'll also learn about the cost of
equity cost of debt and the weighted
average cost of return back at the end
we'll be able to wrap it up with a great
example featuring a company that tries
to assess an investment opportunity and
compares it with other alternatives
sounds great right okay let's dive
straight in and learn more about capital
budgeting capital budgeting also known
as capital asset planning is a term
relating to the decision-making process
companies go through when they must
determine whether to invest in a
specific long term initiative or asset
in addition capital budgeting is used as
a tool allowing company executives to
compare alternatives they have when
making strategic decisions let's provide
a few examples of decisions that merit
an extensive capital budgeting
investment analysis we will typically
use capital budgeting techniques when
assessing the investment in a new
production plant the acquisition of a
new ERP system R&D activities related to
a new project expanding our existing
warehouse purchase or leasing new
vehicles invest a significant amount in
employee training and so on these
projects differ greatly from each other
but have a few traits in common all our
long-term and represent decisions that
will shape the company's success in the
years to come in addition these
initiatives require a significant
initial investment and making the right
calls becomes even more important as
investments can be easily reversed okay
great so capital budgeting is an
assessment method we apply when we must
decide on an investment for which a
large amount of money and risk is
involved decisions are irreversible and
might impact our business for the years
to come
awesome when we try to assess a
project's feasibility we must consider
three main parameters capital that will
be invested the project's timing and the
return we could expect the core
principle of finance is that money today
is more valuable than money tomorrow the
rationale behind it is that money we
receive today has a potential earning
capacity this is why every person would
prefer to receive money sooner rather
than later
hence timing is one of the most
important topics when we talk about
money let's imagine we will be paid
$1,000 and we are offered to choose
whether to receive it today or after one
year if we choose to receive the money
today we can go to the nearest bank and
deposit it for one year given that the
bank wants to attract such deposits it
will pay interest on our money let's
imagine the bank would pay us 3% if we
leave our money there for a year in one
year we will collect our initial $1,000
and we will be paid 3% of $1,000 we will
have 1,000 $30 total had we received
$1,000 after one year we would have
missed the opportunity to earn the
interest of $30.00 money today offers
more opportunities than money tomorrow
okay great
how do we apply this concept in our case
when we build a plant or invest in R&D
today we commit money that is available
now to reap the benefits later that's
what we do ideally we invest money today
and hope we'll be able to get more money
later a capital budgeting exercise aims
to answer the question is it worth
investing X today if we expect to obtain
X plus y a year from now first the
analysis will show us whether the
project will create or destroy value
once we consider the time value of money
and second it would allow us to compare
different investment alternatives and
see which one offers a higher rate of
return we already know money today is
more valuable than money tomorrow we
should remember this when adding sums of
money received at different points in
time imagine the following cash flows
which one is preferable do we want to
receive 100 in year 2 and 110 in year 3
or 100 in year one and 100 in year two
if we simply do the math 210 is better
than 200 so we should pick the first
option this isn't true after we consider
the time value of money in finance we
should never add sums of money without
considering the timing when the cash
flows occur this is very very important
if I deposited 100 dollars in a bank I
would expect to the bank to compensate
me for the right to use my money let's
say the money will stay in the bank for
a year and after 1 year the bank will
repay me the initial amount plus an
interest of 3 percent so we will have
future value equals present value times
1 plus I where present value is the
amount we are depositing and I is the
interest rate the bank will pay us for
depositing our money we would have
future value equals 100 times 1 plus 3%
equals 103 after 1 year we will receive
100 3 dollars what if we want to find
the present value of a future cash flow
how do we find how much a cash flow we
will receive is worth starting from the
equation future value equals present
value times 1 plus I we can simply
divide by 1 plus I and we'll obtain that
the present value equals future value
divided by 1 plus I when we account for
the time value of money in this way
going backwards we talk about
discounting what if we wanted to make
another deposit after year 1 ends we
would have 100 times 1 plus 3% which is
the value at the end
year one and it will be deposited for
another year so at the end of year 2 we
would have 1 plus 3% times 100 times 1
plus 3% equals
future value at year 2 the present value
100 is equal to the future value divided
by 1 plus 3% to the second degree so
when we must discount a future cash flow
that is n years from now we must divide
it by 1 plus I elevated to the nth
degree now that we learn this we can go
to our first example and calculate which
one of the two cash flows has a higher
present value here are the two sets of
cash flows the first one involves a
payment in year 2 that is equal to 100
and another payment in year 3 that is
equal to 110 to calculate present value
assuming an interest rate of 10% we must
use the formula we have here we will
have 100 divided by 1 plus 10% to the
second-degree we are elevating to the
second degree because the cash flow is
two years from now then we will have 110
divided by 1 plus 10% to the 3rd degree
because this is a cash flow in year 3
the present value we will obtain from
this equation is 165 point 3 it's much
lower than the simple sum of 100 and 110
now let's calculate the value of the
other set of cash flows we will have 100
discounted by one year plus 100
discounted by 2 years we obtain that the
present value of the second set of cash
flows is 173 point 5 as you can see by
discounting two sets of cash flows and
obtaining their present value we can
compare them and decide which one is
preferable the selection of the discount
rate is important in this calculation in
addition the timing of cash flows
obviously plays an important role to
write I am sure you'll agree with me
that discount
of cash flows looks like a concept that
is close to the idea of capital
budgeting comparing the value of future
and present cash flows is the main idea
behind the entire exercise it improves
our decision-making process providing a
quantitative means of comparison between
different alternatives a company has
projects consists of an initial capital
outlay which is typically a present
value money we invest now and then
generate a series of cash flows in the
future future values that must be
discounted once we discount these future
values we can compare them with the
amount that's being invested in the
present and calculate a rate of return
of the project a key ingredient in this
exercise allowing us to discount future
cash flows is the discount rate we will
choose this will be the focus of the
next few lessons okay excellent in this
lesson we'll talk about discount rates
we said that to perform a capital
budgeting exercise we must discount
future cash flows and obtain their
present value however we still must
cover a subtle topic which is the
discount rate that should be used for
this calculation well that's up to the
person carrying out the analysis but a
few alternatives are typically used in
different scenarios depending on the
project we are valuing and the way it
will be financed our discount rate could
be the firm's cost of debt the firm's
cost of equity its weighted average cost
of capital or a hurdle rate chosen by
management cost of debt this is the
average interest rate the company pays
on its borrowings it makes sense to use
the cost of debt as a discounting rate
if the entire project is financed with
debt in this case this is the cost the
company sustains to finance the project
hence when we use the cost of debt as a
discounting rate we'll be able to
compare the investment required now and
the present value of the cash flows the
project will generate an alternative
discount rate is the company's cost of
equity there are many ways to calculate
a company's cause
of equity in this course will apply the
one used by investment bankers it is
called the capital asset pricing model
also known as cap M the model was
introduced in the 1960s but remains
relevant to this day and age the capital
asset pricing model suggests a company's
cost of equity is equal to the risk-free
rate plus beta multiplied by the market
risk premium the risk-free rate in an
economy is the rate of return that an
investor would expect from a financial
security that contains zero default risk
the investor buys the security man can
be certain he will be repaid on time and
in full in the complicated world of
today very few securities can be
considered risk-free but most
practitioners use the yield of a ten
year government bond to approximate this
measure the governments of developed
countries have a solid reputation and
can be trusted in a ten year time frame
the rationale behind using a ten year
and not a three month bond is that the
valuation of the firm is a multi-year
exercise hence the risk-free rate used
shouldn't reflect a period as short as
three months the next component in the
calculation is beta this is a
statistical measure for those of you who
love statistics and quantify Nantz beta
can be calculated with the following
formula and it is basically used to show
how a financial security behaves
regarding the rest of the market that is
why we are dividing its covariance with
the rest of the market by the markets
variance if this is confusing
don't worry many financial providers
calculate a company's beta for you let's
open P and G's Yahoo Finance profile as
promised you can't immediately see the
company's beta here it is almost 0.5
which usually is considered a
conservative stock a beta that is less
than 1 indicates the stock is less
volatile than the market a beta of 1
shows the stock is as volatile as the
market if the market gains 1% it will
also gain 1% if the market loses 5% it
will
five percent stocks that have a beta
higher than one are considered
aggressive and are more volatile than
the market if the market grows 2% the
respective stock will probably earn 2.5
or 3% and so on if you get it right
a company's beta will typically have a
value ranging between 0 and 2 the next
component in cap M is market risk
premium theoretically it is given by the
average expected return of the market
minus the risk-free rate academic
research has shown the average market
risk premium rate varies between four
point five percent and five point five
percent and most practitioners use 5
percent in their cost of equity
calculations so we will have the
following the cost of equity in a
company is given by the risk-free rate
in the economy where it operates plus
the company's beta multiplied by five
percent cost of equity is not that
difficult to calculate right you can
find the yield of a ten-year US bond in
Google then we saw that accompanies beta
is available in platforms like Yahoo
Finance and Bloomberg and finally we
multiplied by a constant five percent
easy right if we take a careful look at
Cap M it makes sense a financial
securities return should be composed of
two parts first the risk free rate of
return as a minimum compensating the
investor for the time value of money and
a second component compensating the
investor for the additional risk for
holding a security that is not risk-free
the risk is measured by comparing the
stock to the rest of the market and the
result is that the riskier the stock the
higher its expected return should be
brilliant isn't it so this is how we can
calculate a company's cost of equity the
cap M model is one of the most widely
accepted academic papers on this topic
we can use the cost of equity as a
discounting factor for projects financed
entirely with our own funds with equity
this is an assumption that no debt will
be used to finance the project I'm sure
you'll agree that in practice projects
are not financed with just equity or
debt in 90% of the cases we'll use a
mixture of both one subtlety we didn't
mention in our previous lesson is there
can be a difference between a project's
beta and a company's beta this happens
when a project is financed with a
different amount of leverage than the
typical amount of leverage used by the
company imagine GE wants to build a new
appliances production plant that will
cost approximately six hundred million
dollars it intends to finance the plant
with 70 percent debt and 30 percent
equity the typical debt we see on the
company's balance sheet is around 40
percent its business is highly
diversified and isn't representative of
the beta of a single industry therefore
constructing the plant will have a
different risk profile than the rest of
the company's business the greater the
debt taken up in a project the riskier
it is and the higher its beta will be it
isn't theoretically correct to use the
company's beta to assess the project
under these circumstances how do we
account for that well we must carry out
a few manipulations we must adjust the
company's beta for the risk profile of
the industry in which the project will
be carried out and for the amount of
leverage of the project a company called
X operates exclusively in the appliances
production business has a beta of 0.6 65
percent debt on its balance sheet and a
marginal tax rate of 30 percent okay so
how do we do it
first we must delever company X's beta
this calculation will calculate a beta
independent of the firm's capital
structure to do that we must multiply
company X's levered beta by the
following fraction in our case this will
cause a beta of 0.26 this is company X's
unlevered beta independent of the firm's
capital structure so that's the beta we
will expect companies from this industry
will have when we don't consider their
capital structure okay however we want
to estimate the beta of a specific
project remember therefore I will
multiply company X's beta by the same
denominator we used earlier okay and
this time the numbers we'll use inside
the company we'll use 70 percent debt
and let's assume it's marginal tax is 40
percent right the project specific beta
we obtained is equal to zero point six
three approximately this differs from
the company's beta the reason is that we
considered the specific industry to
which the project will be related and
the concrete debt structure applied by
the company that's a useful technique
that will help you when you work on
sophisticated capital budgeting cases
going forward whenever we must assess a
project which will be financed with both
debt and equity we must use a blend of
the two discount rates right we can't
discount the expected cash flows the
project will produce with the cost of
debt only if the project is financed
with both debt and equity in the same
way we can't use the cost of equity
alone the discount factor that considers
both debt and equity investors is called
weighted average cost of capital or
simply known as WAC it provides a sense
of the average opportunity cost
sustained by investors for investing
their funds in the firm let's look at
the WAC formula it has two weighting
components debt divided by the sum of
debt and equity and equity divided by
the sum of debt and equity the sum of
these two components is equal to one
this shows us that if a project is
prevalently financed with debt the cost
of debt will have a higher weight and
conversely if a project is financed
mainly with equity the cost of equity
will have a higher impact on whack we
shouldn't forget to mention that the
cost of debt component includes a third
factor 1 minus T that considers the fact
that interest expenses are tax
deductible and the cost of debt is lower
than it seems as it provides borrowers
with a
hack shield now that we know how to find
a firm's cost of equity and a firm's
cost of debt it is a piece of cake to
calculate its weighted average cost of
capital that's awesome we are making
excellent progress in our next video
we'll discuss different capital
budgeting techniques thanks for watching
okay great we are doing well so far we
learned what capital budgeting is why
companies use it as a part of their
strategic decision-making process and
why it is critical to get it right we
learned about the time value of money
how to discount cash flows which
discount rates to use and how to apply
the main capital budgeting techniques
used by practitioners that's perfect
in this lesson we'll continue the topic
trying to dig deeper let's describe the
typical sequence of cash flows we can
expect in a capital budgeting exercise
imagine our company intends to build a
plant assembling bicycles and that the
plant would cost an estimated twenty
five million dollars the first cash flow
we would have would be the capital
outflow of twenty five million dollars
we must invest to build up the fixed
asset once the plant is ready working
capital would be needed right we can't
simply assemble bicycles without buying
some parts and holding a certain amount
of inventory it is reasonable to expect
that every project like this one would
require a certain amount of working
capital which would be blocked
throughout the project's lifetime so
that's an additional investment required
imagine the company building a new
bicycle assembly plant has an old one
therefore it can sell some of the
equipment there and this will cause a
positive cash inflow the budget for the
new plant comprises the acquisition of
new machinery and this would allow us to
sell old assets once the plant is ready
the company will assemble bicycles and
will have recurring operating cash flows
from companies buying and distributing
these bicycles recurring operating cash
flows are the main source of income that
will determine whether this will be a
successful project the more bicep
are assembled and the higher the
efficiency with which this is done in
the plant the higher the cash flows
realized throughout the plant's life and
the higher the chances of the project
succeeding if we assume the plant will
be used for 15 years and after that the
company must build a new plant we must
consider the fact that the plant we are
about to build will have a significant
residual value 15 years from now perhaps
some of the machinery will be sold 15
years from now other items will be
recycled or even better someone could be
interested in buying the plant ok did we
forget something oh right
once the project life ends the working
capital we had invested at the beginning
to buy inventory parts for bicycles
would be freed up perfect these are the
main events that have a cash impact and
that we must plan for in a capital
budgeting exercise in our next lesson
we'll discuss how to forecast these
items that's exciting right in the
previous lesson we discussed the typical
cash flows we must plan when performing
a capital budgeting exercise and that's
a solid foundation that brings us one
step closer to performing a
sophisticated capital budgeting exercise
however to do that we must be able to
forecast each item and create a
numerical simulation of the insights our
team has about the project first we must
estimate the actual investment needed
for the project depending on whether we
plan to build a plant invest in IT or
something else we must make sure we have
a good idea about the money needed to
complete the project things become
easier if we sign a contract with a
third party and they bare the risks
associated with cost overruns otherwise
if we invest in building a new facility
and construction becomes more expensive
than initially thought the entire
project assessment we have prepared with
the capital budgeting exercise becomes
irrelevant so it is key to understand
whether the initial investment is a
fixed amount or an estimation that will
likely change
the project starts if we are in the
second scenario we should perform a
sensitivity analysis that would allow
decision makers to see how the project's
financials will look in different states
of the world like creating different
scenarios in which the plant we are
building costs different amounts once
the project has been completed it will
serve its purpose in our example from
earlier the plant will produce bicycles
and generate money how much though well
here's the tough part
we must estimate how much money will be
made before the project starts this
involves assessing the demand for
bicycles and making an assumption about
the price at which they will be sold not
only a year from now but throughout the
life of the entire project by estimating
the potential demand and the price at
which the company can sell bicycles will
obtain a projection of revenue figures
then comes the matter of estimating
expenses here we can have plenty of
unknowns the price of bicycle parts our
plant uses could change cost of labour
increases over time plus there can be
other unexpected factors along the way
the important thing is to model expenses
in sync with revenues and respect the
assumptions we've made when forecasting
revenues most practitioners prefer
modeling cogs and OPEX costs as a
percentage of revenue and this can be a
potentially viable approach especially
in the long run when we must forecast
five or more years ahead
it is difficult and impractical to do it
for each line item right once we've
modeled revenues and cogs we must think
about the cash flow effect that will
derive from balance sheet items we
already said working capital investment
will likely represent significant cash
tied up into the project inventory trade
receivables and trade payables are three
items we must consider the day's
technique we studied earlier would allow
us to forecast these items in line with
revenues and cogs we've assumed earlier
depending on the project your company is
working for
you may want to consider the impact of
other balance sheet items too for
example in certain legislations we could
deduct certain costs earlier which will
give rise to deferred tax liabilities if
so and the amount is serious we should
take deferred taxes into consideration
when coming up with cash flow
estimations at this point we've
estimated all P&L and balance sheet
items necessary for calculating
recurring cash flows and this takes us
to the end of our project when we can
expect two types of inflows one deriving
from selling the residual assets related
to our project and another from the
freeing up of working capital the
terminal disposal price of the asset
we've invested in is determined by its
degree of obsolescence if this is an
asset that ages quickly then the
terminal price will be a small fraction
of its original price however it is also
possible to have an asset that is still
valuable and can be sold at a good price
usually companies use the services of
specialized personnel who can value such
assets and come up with a concrete value
for your reference in some models
terminal value could be as low as 3 or 5
percent while in others it can be even
40% it depends on the type of asset we
are considering the estimation of
working capital freed up at the end is
easy we've projected working capital
values until the end of the project's
useful life the amount of capital that
will be freed up at the end is the same
as the amount of capital we used in the
last year of projections ok great this
is how we come up with the numbers that
would allow us to carry out a proper
capital budgeting exercise thanks for
watching this lesson
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