Video Transcript: Capital Budgeting

Hello, welcome. We're going to be discussing capital budgeting. What is capital  budgeting? Capital Budgeting is the process in which a business determines  and evaluates potential expenses or investments that are large in nature. These  expenditures and investments include projects such as building a new plant or  investing in a long term venture. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the potential  returns generated meet a sufficient target benchmark, also known as investment appraisal. Ideally, businesses should pursue all projects and opportunities that  enhance shareholder value. However, because the amount of capital available  at any given time for new projects is limited, management needs to use capital  budgeting techniques to determine which projects will yield the most return over  and over an applicable period of time. Various methods of capital budgeting can  include through throughput analysis, net present value, internal rate of return,  discounted cash flow and payback period. Throughput analysis is measured as  the amount of material passing through a system. Throughput analysis is the  most complicated form of capital budgeting analysis, but is also the most  accurate in helping managers decide which projects to pursue. Under this  method, the entire company is considered a single profit generating system. The analysis assumes that nearly all costs in the system are operating expenses that a company needs to maximize the throughput of the entire system to pay for  expenses, and that the way to maximize profits is to maximize the throughput  passing through a bottleneck operation. A bottleneck is the resource in the  system that requires the longest time in operations. This means that managers  should always place higher consideration on capital budgeting projects that  impact and increase throughput passing through the bottleneck. This does not  mean that all other capital budgeting proposals will be rejected, since there are  a multitude of possible investments that can reduce costs elsewhere in a  company, and which are therefore worthy of consideration. However, throughput is more important than cost reduction, since throughput has no theoretical upper limit, whereas cost can only be reduced to zero given the greater ultimate  impact on profits of throughput over cost reduction, any non bottleneck proposal  is simply not as important. Discounted cash flow analysis, any capital  investment involves an initial cash outflow to pay for it, followed by a mix of cash inflows in the form of revenue or a decline in existing cash flows that are caused by expenses incurred. We can lay out this information in the spreadsheet to  show all expected cash flows over the useful life of an investment, and then  apply a discount rate that reduces the cash flows to what they would be worth at the present date. This calculation is known as net present value. Net Present  Value is the traditional approach to evaluating capital proposals, since it is based on a single factor, cash flows that can be used to judge any proposal arriving  from anywhere in a company. For example, ABC company is planning to acquire an asset that expects will yield positive cash flows for the next five years. Its 

cost of capital is 10% which it uses as the discount rate to construct the net  present value of the project. The following table shows the calculation. So we're  going to discount the cash flows right as we just did in the previous lesson. We'll use the same formula to project out the discounted cash flows. So payback  analysis, the simplest and least accurate evaluation technique is a payback  method. This approach is still heavily used because it provides a very fast back  of the envelope calculation of how soon a company will earn back its  investment. This means that it provides a rough measure of how long the  company will have its investment at risk before earning back the original amount expended. Thus, it is a rough measure of risk. There are two ways to calculate  the payback period, which are the simplified version, we divide the total amount  of an investment by the average resulting cash flow. This approach can yield an  incorrect assessment, because a proposal with cash flows are skewed far into  the future can yield a payback period that differs substantially from when the  actual payback occurs. A manual calculation deducts the forecasted positive  cash flows from the initial investment amount from year one forward until the  investment is paid back. This method is slower to calculate, but ensures a higher degree of accuracy. So in the payback analysis, we want to know how quickly  are we going to recoup our initial investment and move to break even and not be not have a negative value. Again, net present value is the difference between  present value of cash inflows and the present value of cash outflows. NPV, or  net present value, is used in capital budgeting to analyze the profitability of a  projected investment or project. A positive net present value indicates the project that the projected earnings generated by a project or investment in present  dollars exceeds the anticipated costs, also in present dollars. Generally, an  investment with a positive net present value will be a profitable one, and one  with a negative net present value will result in a net loss. This concept is the  basis for the net present value rule, which dictates that only investments that  should be made are those with net present value, positive net present value  values. Internal rate of return is a metric used in capital budgeting measuring the profitability of potential investments. The internal rate of return is a discount rate  that makes the net present value of all cash flows from a particular project equal to zero. Internal Rate of Return, calculations rely on the same formula as NPV.  Generally speaking, the higher a project's internal rate of return, the more  desirable it is undertake. The project IRR is uniform for investments of varying  types, and as such, internal rate of return can be used to rank multiple  prospective projects a firm is considering on a relatively even basis, assuming  the cost of investment are equal among the various projects, the project with the highest RR would probably be considered the best and undertaken first.