Capital Budgeting

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Capital Budgeting Preliminary

0 1 2 3 4 5

sunk costs

How do you decide whether to do a particular project or make a particular investment?

How do you rank projects within your capital budget?

The projects have annual cash flows, CFi

What is the cash flow?

What is the discount rate ?

Expected Project Cash FlowsAssume there are three future cash flow scenarios, A, B, and C during some future year. The expected cash flow is during that year is

The scenarios are mutually exclusive – independent Example

CFA = $1,000,000 with probability 50% CFB = $500,000 with probability 30% CFC = $150,000 with probability 20%

The risk (variance) in the expected cash flow is included in the discount rate

1p p p

pCFpCFpCFCFE

CBA

CCBBAA

000,680$

%20000,150$%30000,500$%50000,000,1$ CFE

State-ment of Cash Flows

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Statement of Cash Flows

This financial statement details the change in the balance sheet cash and equivalents accounts, CE, during an accounting period.

CEi = CEi-1 + CFOi + CFIi + CFFi

= CEi-1 + ∆CE

∆CE = CFO + CFI + CFF

CFO is the cash flow from operating activities CFI is the cash flow from investing activities CFF is cash flow from financing activities

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7

0 1 2

Internal Rate of Return

260

-100 -165

Solve for the two roots of the second order polynomial. The smallest root is the internal rate of return

Cash Flow

Since discounting at the cost of capital, the project cash flow should be computed similarly to the firm’s free cash flow

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Balance Sheet

Assets Liability & EquityCE

‘Non-Capital’

Capital

Statement of Cash Flows

Net cash from operating activities From OA From NOA Net cash used by investing activities For OA For NOA

Net cash from financing activities

DCE

CFO

CFICFF

FCF

CFO *

CFI*

Investors

∆CE = CFO + CFI + CFF

FCF = CFO* + CFI*

Free Cash Flow

FCF = CFO* + CFI*

CFO* = CFO - IDI (1-∙ t) + IX (1-∙ t)

= NP + DX + ∆T –DNWC - DG - IDI (1-∙ t) + IX (1-∙ t)= (EBIT – IX)·(1 – t) + DX + ∆T- (∆OWC - DOCE) - CS + CC - IDI (1-∙ t) + IX (1-∙ t)= (EBIT – IDI)·(1 – t) + ∆T + DX - (CS – CC) - (∆OWC - DOCE)= NOPAT + DX - CS + CC - ∆OWC + DOCE

CFI* = CFI - DIS + DOCE= -CX + DIS + CS - DIS - DOCE = - CX + CS - DOCE

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From CFO: Remove effective non-operating cash flow and add back effective cash flow to debt providers.

From CFI: Remove non-operating cash flow, DIS, and add cash needed for business operations, DOCE

At Fairway at IDI and IX transactions are cash

Free Cash Flow 10

FCF = CFO* + CFI*

= NOPAT + DX - CS + CC - ∆OWC + DOCE - CX + CS - DOCE = NOPAT – (CX - DX – CC) - ∆OWC

= NOPAT – DNC – DOWC

= NOPAT – DIC