ACST101 Lecture Notes - Lecture 8: 0 (Year), Discounted Cash Flow, Capital Budgeting
29 Jun 2018
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ACST101 LECTURE – 3/5/18
WK11; FUNDAMENTALS OF CAPITAL BUDGETING
THE IMPORTANCE OF CAPITAL BUDGETING
oCapital budgeting decisions are the most important investment decisions made by
management.
oThe goal of these decisions is to select capital projects that will increase the value of
the company.
oCapital budgeting techniques help management to systematically analyse potential
business opportunities in order to decide which are worth undertaking.
CLASSIFICATION OF INVESTMENT PROJECTS
Capital budgeting projects can be broadly classified into three types;
1. Independent Projects
oAccepting one project won’t mean you can’t accept others (if you have the
funds). Cash flows of each unrelated.
2. Mutually Exclusive Projects
oChoose between projects e.g. a new printer. Accepting one excludes the other(s)
choice.
3. Contingent Projects
oAccepting a project depends on accepting another.
BASIC CAPITAL BUDGETING TERMS
oThe cost of capital is the minimum return that a capital budgeting project must
earn for it to be accepted. It is an opportunity cost since it reflects the rate of
return investors can earn on financial assets of similar risk.
oCapital rationing – when a company does not have the resources necessary to
fund all of the available projects. e.g. limited to $2 million capital expenditure
Thus, the available capital will be allocated to the projects that will benefit the
company and its shareholders the most*.
* The profitability index (PI) (included in Case Study 2 but not examined in this unit) is used
to determine the combination of projects that gives best total NPV where capital rationing
exists.
NET PRESENT VALUE (NPV)
It is a capital budgeting technique that is consistent with goal of maximising shareholder
wealth.
oThe method estimates the amount by which the benefits or cash flows from a
project exceeds the cost of the project in present value terms
NPV VALUATION OF REAL ASSETS
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Valuing real assets calls for the same steps as valuing financial assets
oEstimate future cash flows
oDetermine the investor’s cost of capital or required rate of return
oCalculate the present value of the future cash flows
THE BASIC CONCEPT
The present value of a project is the difference between the present value of the expected
future cash flows and the initial cost of the project
oAccepting a positive NPV project leads to an increase in shareholder wealth,
while accepting a negative NPV project leads to a decline in shareholder wealth
oProjects that have a NPV equal to zero implies that management will be
indifferent between accepting and rejecting the project
Some practical difficulties in following the process for real assets
1. Cash flow estimates have to be prepared in house and are not readily available
2. Estimates of required rates of return are more difficult than it is for financial assets
because no market data is available for real assets
FRAMEWORK FOR CALCULATING NPV
The NPV technique uses the discounted cash flow technique
oOur goal is to calculate the net cash flow (NCF) for each time period t, where;
NCFt= (Cash inflows – Cash outflows) for the period of t
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find more resources at oneclass.com
A FIVE STEP APPROACH TO CALCULATE THE NPV
1. Determine the cost of the project:
oIdentify and add up all expenses related to the cost of the project
oMost project’s entire cost occurs at the start of the project, some projects may
have costs occurring beyond the first year
oThe cash flow in year 0 (NCF0) is negative, indicating a cost
2. Estimate the project’s future cash flows over its forecasted life:
oBoth cash inflows (CIF) and cash outflows (COF) are likely in each year of the
project
oNeed to recognise any salvage value from the projects in its terminal year
3. Determine the riskiness of the project and estimate the appropriate cost of capital:
oThe cost of capital is the discount rate used in determining the present value of
the future expected cash flows (opportunity cost, minimum required return)
oThe riskier the project, the high the cost of capital for the project
4. Calculate the project’s NPV
oDetermine the difference between the present value of the expected cash flows
from the project and the cost of the project
5. Make a decision:
oDECISION RULE: Accept the project if it produces a positive NPV or reject the
project if NPV is negative
find more resources at oneclass.com
find more resources at oneclass.com
