Introduction to Capital Budgeting

Summary

The 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

00:00

💼 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.

05:02

📊 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.

10:02

🏦 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.

15:03

🔄 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.

20:03

🛠️ 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.

25:04

📈 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.

Keywords

💡Capital Budgeting

Capital budgeting is a strategic decision-making process used by companies to determine whether to invest in long-term initiatives or assets. It is critical for evaluating investments that require significant capital outlays and have a substantial impact on the company's future. In the video, it is used to discuss the evaluation of projects like building a new production plant or investing in R&D activities.

💡Time Value of Money

The time value of money is a financial concept that asserts that money available today is worth more than the same amount in the future due to its potential earning capacity. This principle is fundamental to capital budgeting as it helps in evaluating future cash flows by discounting them to present value, as illustrated in the script with the example of depositing money in a bank.

💡Discounted Cash Flows (DCF)

Discounted cash flows refer to the process of calculating the present value of future cash flows using a discount rate. This method is essential in capital budgeting for assessing the viability of investments. The script explains that by discounting future cash flows, investors can determine whether the expected returns from an investment justify its initial cost.

💡Net Present Value (NPV)

Net present value is a financial metric used to determine the worth of an investment by subtracting the initial investment from the present value of the future cash flows generated by the investment. In the context of the video, NPV is one of the techniques introduced to answer whether an investment makes sense economically.

💡Internal Rate of Return (IRR)

The internal rate of return is the discount rate that makes the NPV of a project zero. It is used to evaluate the profitability of potential investments. IRR is discussed in the video as a technique to compare different investment alternatives and to assess if the expected returns are sufficient to justify the investment.

💡Discount Rate

A discount rate is the interest rate used to determine the present value of future cash flows. Selecting an appropriate discount rate is crucial in capital budgeting as it directly affects the calculation of NPV and IRR. The video mentions that discount rates can include the firm's cost of debt, cost of equity, or a hurdle rate chosen by management.

💡Cost of Equity

Cost of equity is the return that shareholders require for investing in a company's stock. It is calculated using models like the Capital Asset Pricing Model (CAPM), which is introduced in the video. The cost of equity is used as a discount rate for projects financed with equity, reflecting the risk associated with equity investment.

💡Cost of Debt

Cost of debt is the average interest rate a company pays on its borrowings. It is considered a lower risk investment compared to equity and is used as a discount rate when the project is entirely financed with debt. In the script, it is mentioned as an alternative discount rate for capital budgeting calculations.

💡Weighted Average Cost of Capital (WACC)

WACC is a financial metric that calculates the average cost of capital for a company, taking into account the mix of debt and equity used to finance its projects. It is used as a discount rate in capital budgeting when a project is financed with a combination of debt and equity. The video explains how to calculate WACC and its importance in investment decision-making.

💡Sensitivity Analysis

Sensitivity analysis is a technique used to determine how different values of an input variable affect a particular projected variable. In the context of the video, it is suggested as a method to analyze how changes in the initial investment cost could impact the financial outcomes of a project, thus helping decision-makers assess risk.

💡Terminal Value

Terminal value is the estimated cash flow that a project is expected to generate at the end of its useful life. It is an important component in capital budgeting as it represents the residual value of the investment. The video discusses how to estimate terminal value by considering factors like asset obsolescence and potential sales proceeds.

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