Recap from previous lecture
• Importance of working capital management
Learning Objectives
1. Explain the importance of capital budgeting
2. Estimate project’s free cash flow
3. Apply capital budgeting techniques to project’s cash flow to estimate
project’s value
4. Explain the relationship between NPV and firms’ share price
5. Be able to compare NPV and other investment decision criteria
• Operating cycle and cash conversion cycle
•Short-term working capital management is essential for maintaining
liquidity, operational efficiency – critical for smooth functioning and long-
term success of a business.
Importance of capital
budgeting Fixated on the future
• Accounting & financial analysis is preoccupied with characterizing the past and present. In contrast, finance
professionals look to the future for the important questions regarding the value implications of any decisions.
• In short, the source of all value today is future performance as manifested in cash.
• Whether you buy stock, acquire a company or buy a house, you need to go through a process of valuation, and
finance has a rigorous set of tools for thinking about how to make those decisions.
• Capital budgeting is arguably the most important issue in corporate finance
• Finance managers frequently face broader issues like whether they should launch a new product or enter a
new market
• Decisions like these determines the nature of the firm’s operations and products to come, primarily because
fixed assets investments are generally, long-lived, expensive and not easily reversed once they made
• The asset choice will require the firm to commit its scarce and valuable capital ($$$)
Importance of capital
budgeting Capital budgeting for valuation Free cash flow: Capital Expenditure
• Free cash flow is one of the most important measure of economic performance in finance. This number appears when
• How a firm chooses to finance its operations (capital structure decisions), how a firm manages its short-term you look at how companies are valued or when companies discuss how they are doing
operating activities (working capital questions) are issues of concern, BUT the fixed assets define the business of
• The equation for calculating free cash flow provides a measure of the amount of cash flows truly unencumbered by
the business of the firm
the operations of a business – it is the purest form of cash and forms the basis of valuation.
• For example, Airline companies require airplanes to operate their business, regardless how they finance
them • It removes the distorting effects of non-cash charges such as depreciation and amortization and finally, acknowledges
that capital expenditures are required for growth
• Any given company have numerous possible investments to consider. Each potential investment is an option to • Free cash flow are necessary for maintaining or expanding the company’s operations.
consider: Some of these options may create value, other options may not
• Therefore, the essence of successful financial management is learning to identify which are valuable or not
To calculate free cash flow
Earnings Before Interest and Taxes
− Taxes
= Earnings before interests after taxes
+ Depreciation and amortization
± Changes in working capital
− Capital expenditure

Free cash flow

Project Cash flows: Identifying the relevant CF Identifying

Incremental cash flows
relevant cash flows

• The effect of taking up a project/investment is to change the firm’s overall cash flow today and in
the future. • Only cash flows that are incremental and that result from a project
• To evaluate a proposed investment, we must consider these changes in the firm’s cash flows and • To decide whether a cash flow is incremental, finance managers must identify them when
then decide if they add value to the firm considering whether to include them in our analysis.
• Therefore, the first and most critical step is to decide which cash flows are relevant • (1) Sunk Costs
• (2) Net working capital
• (3) Financing costs
So, what is a relevant cash flow for a project?
• A relevant cash flow for a project is to change in the firm’s overall future cash flow that comes
about as a direct consequence of the decision to take that project.
• Defined in terms of changes in, or increments, to a firm’s existing cash flow, they are called
incremental cash flows associated with the project.
• Important: This approach means we evaluate the proposed project purely on its own merits, in
isolation from any other activities or projects.
 Identifying 1.Sunk cost
relevant cash flows
• Sunk cost is defined as a cost that have already been incurred
• such a cost cannot be changed by the decision today to accept or reject a project
• In other words, the firm will have to pay for this cost no matter what
• Based on the discussion on the definition of incremental cash flow, sunk cost is clearly not
relevant to the decision at hand.
• Finance managers must always be careful to exclude sunk costs in their analysis
Example of a sunk cost
Suppose Pumpkin Spice Company hires a financial consultant to help evaluate whether a line of
pumpkin spice lattes should be launched.
• Consulting fee is a sunk cost – It must be paid whether or not the pumpkin spice lattes is
actually launched
Identifying
relevant cash flows Net working capital (Con’t)
• Net working capital is an important feature in capital budgeting.
• When a project winds down, inventories are sold, receivables are collected, bills are paid, and
cash balances can be drawn down.
• These activities free up the net working capital originally invested
• It can be said that the firm’s investment in project net working capital closely resembles a
loan – The firm supplies working capital at the beginning and recovers it towards the end
Identifying 2. Net working capital
relevant cash flows
• It is normal practice a project will require that the firm invest in net working capital in addition
to long-term assets.
• For example: A project will generally need some amount of cash on hand to pay any expenses
that arises.
• In addition, projects will also need an initial investment in inventories and accounts
receivables (to cover credit sales)
• Some of the financing for this will be in the form of amounts owed to suppliers (accounts
payable)
• But the firm will have to supply the balance. This balance represents the investment in net
working capital
Identifying
relevant cash flows 3. Financing Costs
• When analyzing a potential investment, finance managers does not consider interest paid or
any other financing costs such as dividends or principal repaid because they are interested in
the cash flow generated by the assets of the project
• In Lecture 2’s bond valuation, we understand interest paid (coupon payments) is a component
of cash flow to investors, not cash flow from assets
• The goal in project evaluation is to compare the cash flow from a project to the cost of
acquiring that project in order to estimate NPV, as established in Lecture 5
• The mix of debt and equity a firm actually chooses to use in financing a project (capital
structure) is a managerial variable that primarily determines how a project cash flow is divided
between owners (shareholders) and creditors (debtors)
• This does not mean financing arrangements are not important. It is something to be analysed
separately.
 Develop the Project cash flow
Develop the
project cash flow
Develop the cash flow: An example
project cash flow

• The first task a finance manager needs to do when evaluating a proposed investment is a set of
projected financial statements, also known as pro forma
• Once the finance manager can develop the projected cash flows from the project, then the
value of the project can be estimated using the capital budgeting techniques
• To prepare these statements, we will need estimates of quantities such as unit sales, the selling
price per unit, the variable cost per unit, and total fixed costs. We also need to know the total
investment required, including any investment in net working capital
Suppose Black Widow Inc thinks they can sell 50,000 cans of shark attractant per year at price of
$4 per tin. It costs the company about $2.50 per tin to produce the attractant, and a new product
such as this one typically only has a three-year life. The company requires a 20% return on new
products.
Fixed cost for this project, including things such as rent on the production facility, will run
$12,000 per year. Further, Black Widow will need to invest a total of $90,000 in manufacturing
equipment. For simplicity, we assume that this $90,000 will be 100% depreciated over the 3-year
life of the project. Furthermore, the cost of removing the equipment will roughly equal its actual
value in 3-years, so it will be essentially worthless on a market value basis as well. Finally, the
project will require an initial $20,000 investment in net working capital, and the tax rate is 34%

Develop the Develop the

project cash flow project cash flow

Table 1: Projected Income statement Table 2: Projected Capital requirements

Sales (50,000 units at $4/unit) $200,000 Year

Variable costs ($2.50/unit) 125,000 0 1 2 3
75,000 Net working capital $20,000 $20,000 $20,000 $20,000
Fixed costs 12,000 Net fixed assets 90,000 60,000 30,000 0
Depreciation ($90,000/3) 30,000 Total investment $110,000 $80,000 50,000 $20,000
Earning before interest and taxes 33,000
Taxes 11,220
Net income 21,780 In Table 2, we have net working capital of $20,000 in each year. Fixed assets at the start of the
project’s life (Year 0), and they decline by the $30,000 in depreciation each year, ending up at zero.
Table 1 organizes these initial projections by first preparing the pro forma income statement.
Observe that this income statement does not consider interest expense. As noted earlier, interest
expense is a financing expense and not considered.
 Develop the
Develop the
project cash flow 1. Project’s operating cash flow
project cash flow Project cash flow
• To determine the operating cash flow associated with a project, we understand the definition of
operating cash flow:
Now, we convert this accounting information into cash flows.
Operating cash flow = Earnings before interest and taxes – Taxes +
Depreciation
• To develop cash flows from a project, cash flows from assets has three components:
To illustrate the calculations of operating cash flow, we will use the projected information from the Black
(1) Operating cash flow Widow project.
(2) Capital spending
(3) Changes in net working capital
Table 3: Projected Income statement
• To evaluate a project, the finance manager must estimate each of these. Once the estimate of Sales $200,000
each component is computed, then the cash flow from the project can be calculated Variable costs 125,000 Table 3 repeats the income
Fixed costs 12,000 statement according to the
Depreciation 30,000 definition of operating cash
Project cash flow = Project operating cash flow – Project change in net working flow
capital – Project capital spending Earning before interest and taxes 33,000
Taxes (34%) 11,220
Net income 21,780

Develop the
project cash flow 1. Project’s operating cash flow 2. Project’s net working capital + 3. Capital spending
(Con’t)
• After calculating the operating cash flows, we next take care of the net working capital
Table 4: Projected operating cash flow requirements and fixed asset. Based on our example, we know Black Widow company must spend
$90,000 up-front for fixed-assets and investment and additional $20,000 in net working capital.
EBIT $33,000 Table 5: Projected total cash flows
Taxes - 11,220
Year
Depreciation +30,000 0 1 2 3
Operating cash flow $51,780 Operating cash flow $51,780 $51,780 $51,780

Changes in net working capital - $20,000 - - +$20,000

In Table 4, we see projected operating cash flow for the project is $51,780
Capital spending - $90,000
Total Project cash flow -$110,000 $51,780 $51,780 $71,780

Therefore, immediate cash outflow is $110,000. At the end of the project’s life, the fixed assets will be worthless, but the
firm will recover the $20,000 that was tied up in working capital. This will lead to $20,000 inflow in the last year
 Importance of capital
Develop the project Estimating Net Present Value
cash flow Projected total cash flow and value budgeting

• The goal of financial management is to create value for shareholders. One of the key role of the financial
managers is to examine a potential investment which is likely to affect the price of the firm’s share.
Now that we have cash flow projects, we can apply one of the capital budgeting techniques
• An investment is worth undertaking if it creates value for its owners → positive NPV

• Expenditure on both tangibles and intangible assets are investments. In either case, the firm is spending money
today in hopes of generating a stream of future profits.
Find the NPV for Black Widow, at the 20% required return
• NPV depends on expected future cash flow. Cash flows are simply the difference between cash received and cash
51,780 51,780 71,780 paid out.
𝑁𝑃𝑉 = −$110,000 + + + = $10,648
1.20 1 1.20 2 1.20 3
• To estimate the value of a business, we apply the discounted cash flows (DCF) to value those cash flows. Once we
have this estimate, we can estimate NPV as the difference between the present value of the future cash flows
Based on these projections, the project creates over $10,648 in value and should be accepted. and the cost of the investment

IRR: The required rate of return for this project is 20%. Since the NPV is positive, it is very likely, the IRR is • DCF model 𝑉0 = 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤)
greater than 20%. After calculating the IRR, we find the IRR to be 25.8%
• When selecting between accepting or rejecting a project, the NPV rule indicates we should accept a project if its
NPV is positive.

Gold standard for

valuation Discounted cash flows The relationship between
Effect of NPV on Share Price
NPV and share price

• Free cash flows are flows that assets generate that are truly free and truly cash. They are available to capital
providers (equity & debt holders) after taking into consideration for costs and expenses.
• Free cash flows can be deployed for new investments, or they can be distributed to capital providers (e.g., • Suppose we believe cash revenues from our fertilizer business will be $20,000 per year, assuming
dividends to shareholders)
everything goes as expected (including taxes) will be $14,000 per year. We will wind down the
• The discounted cash flows is the gold standard of valuation.
• assets derive their value from their ability to create future cash flows, and those cash flows are not created business in 8 years. The plant, property and equipment will be worth $2,000 as salvage at that
equal – they require discounting to translate them to today’s numbers (present value).
time. The project costs $30,000 to launch. We use a 15% discount rate. If there are 1,000 shares of
stock outstanding, what will be the effect on the price per share of taking this investment?

• Important question: Is this a good investment?

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = + …
1+𝑟 1 1+𝑟 2 1+𝑟 𝑁
 The relationship between
The relationship between Effect of NPV on Share Price
NPV and share price
Effect of NPV on Share Price NPV and share price

Total present value would be calculated as follow:

We first need to calculate the present value of the future cash flow at 15% discount rate. The net cash inflow will 1
1−
𝑃𝑉 = $6,000 × 1.158 + $2,000
be $20,000 cash income less $14,000 costs per year for 8 years. These cash flows are illustrated below. As the 0.15 1.158
timeline shows, we effectively have an eight-year annuity of $6,000 ($20,000 - $14,000), along with a single lump
sum of $2,000 in the 8th year. = $27,578

We then compare the computed present value with the estimated $30,000 cost. Therefore, the NPV of this project is
0 1 2 3 4 5 6 7 8
𝑁𝑃𝑉 = −$30,000 + $27,578 = −$2,422

-$30,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 + $2,000 The NPV is negative, therefore this is not a good investment. Based on the calculations, accepting this investment would
decrease the total value of the stock by -$2,422
=$8,000
With 1,000 shares outstanding, we estimate the impact of taking this project is a loss of value of -$2,422/1000 = -$2.42
per share

The relationship between Net present value for NPV with perpetual cash flow
Effect of NPV on Share Price
NPV and share price perpetuity stream

• The example tells us how NPV estimates can be used to determine whether an investment is desirable. From
the example, we see that if NPV is negative, the effect on share will unfavourable.
• Therefore, all we need to know about a particular proposal is for the purpose of making an accept or reject
decision is whether the NPV is positive or negative.
Researchers at Frederick’s Feed and Farm have a made a breakthrough. They believe they can produce a new,
environmentally friendly fertilizer at a substantial cost savings over the company’s existing line of fertilizer. The
fertilizer will require a new plant that can be built immediately at a cost of $250 million. Financial managers
estimate that the benefits of the new fertilizer will be $35 million per year, starting at the end of the first year
and lasting forever, as shown by the following timeline:

0 1 2 3
The net present value rule can be stated as follow:

An investment should be accepted if the net present value is positive and rejected
if it is negative. -$250m $35m $35m $35m
𝑪𝑭
Perpetuity formula
$35𝑚 𝒓
𝑁𝑃𝑉 = −$250𝑚 + = $100𝑚
0.10

The NPV investment rule indicates that by making the investment, the value of the firm
will increase by $100m today, so Frederick should undertake this project.
 Mutually Exclusive vs Mutually exclusive projects: Choosing Mutually Exclusive vs
Independent between projects Independent Independent projects

• Often time, a firm must choose the one project from several possible projects – This means that the choice is
mutually exclusive.
• For example: A manager may be evaluating alternative package designs for a new products. When choosing any
one project exclude us from taking the others, we are facing mutually exclusive investments
• When projects are mutually exclusive, we need to determine which projects have positive NPV and then rank the
projects to identify the best one.
• In the case of NPV, the NPV rule is rather straightforward: Choose the project with the highest NPV
• NPV is expressed as the value of the project in terms of cash today, picking the project with the highest NPV leads to
the greatest increase in wealth
• On the other hand, when it comes to selecting independent projects, the company may pick more than one NPV
positive projects
• These are projects whose cash flows and acceptance are not affected by the decision of other projects.
Therefore, the acceptance one project does not influence the decision of any other project. Because both
investments do not affect each other.
• For example, A pharmaceutical company is deliberating on funding a research project for a new drug and to
launching a marketing campaign for an existing product. The decision on the research project does not affect
the marketing campaign decision

Of course, select both only if both are NPV positive

Mutually Exclusive vs Other decision rule Problematic methods for assessing value: Payback
Independent Question criteria period

What should a company do if both projects have negative NPV?
• Reject both projects – A negative NPV indicates that the project is expected to generate less
return than its costs, suggesting value destruction than value creation.
• Payback method assess projects based on the amount of time it would take for investors to get their money back.
• This method considers the length of time it takes to recover the cost of initial investment
• I.e. In what year does the company recover its initial investment? – This appears to be an appealing way to
think about whether an investment is attractive or not.

• Then, re-evaluate assumptions. It is important to revisit the assumptions and projections that Choose between two projects, each requires a $900,000 investment. You can choose only one and use payback
led to these negative NPVs – Cash flow estimates, discount rate and other variables. Was the period as your criterion. The table below shows the projected cash flows for each project.
estimate too conservative?

• Look at alternatives – Are there any other options that could generate a positive NPV? Finance
managers should explore all options before committing funds. Which project would you choose?
 Other decision rule Problematic methods for assessing value: Payback Other decision rule Problematic methods for assessing value: Internal
criteria period (con’t) criteria rate of returns (IRR)
• As this example illustrates, the payback period method has some significant problems. • Using internal rates of return (IRR) to assess projects is another very common valuation method.
• (1) By comparing these flows over time this way, the time value of money is ignored. • IRR is used to estimate the profitability of potential investment – It is the discount rate that makes the NPV of all
• (2) Even worse – problem is that the answer to a payback period analysis is a simple number of years cash flow equal to zero in a discounted cash flow analysis
• In comparison to payback period, the IRR is not as problematic partially because it is closely linked to discounted
However, this is not what financial managers are interested in → They are interested in creating value. The payback cash flows – But there are still problems.
period could lead you to choose an investment because it recovers the cost quickly, but turns away investments that
create more value Example: Consider a project that costs $100 today and pays $110 in one year. Suppose we want to find out “What is
the return on this investment? It is obvious to say that the return is 10% because for every dollar invested, we get
$1.10 back. We can say that this 10% is the internal rate of return on this investment
Using a discount rate of 10%, we can find the NPV of both investments → Project B has a higher NPV
By using payback period, you selected 110
$500,000 $500,000 $300,000 𝑁𝑃𝑉 = −$100 + This 10% is what we call the
Project A = −$900,000 + + 1.10 2 + 1.10 3 = $193,160 the project with considerably lower (1 + 𝑅) return on this investment.
1.10 1
NPV, which leads to much less value 110 Illustrated here is the IRR on
creation. 𝑁𝑃𝑉 = 0 = −$100 + the investment, which is the
$0 $0 $1,670,000 (1 + 𝑅)
Project B = −$900,000 + + + = $𝟑𝟓𝟒, 𝟕𝟎𝟎 $110 discount rate that makes NPV
1.10 1 1.10 2 1.10 3
This comparison shows why payback $100 = equals to zero
(1 + 𝑅)
analysis is problematic 𝑟 = 10%

Other decision rule Problematic methods for assessing value: Internal Other decision rule
criteria rate of returns (IRR) criteria Conclusion

• Ultimately, a good capital budgeting criterion must tell us two things:

• In other words, IRR analysis captures the rate of return that will be experienced if the forecast is realized for a
problem
• The idea of a rate of return is very powerful and you can compare it to the weighted average cost of capital or
discount rate (IRR > cost of capital)
• While this is an appealing, IRRs are problematic for two reasons
• (1) IRRs can give you the wrong answer because they are focused on returns and not value creation –
Financial managers can compare two projects, and the higher IRR project might actually lead to less value
creation. Remember that value creation is the goal, not rate of return maximization
• (2) If cash flows are characterized by fluctuations of inflows and outflows throughout a project’s life, IRRs
can give you wrong answers.
• If cash flows starts off as positive and then becomes negative → can affect decision.
• Ultimately, only NPV at the cost capital is the main calculation to determine acceptability
• (1) Is a particular project a good investment ? It should tell how much value can be created.
• (2) If we have more than one good project, but we can take only one of them, which one should we take?
• Among some of the techniques discussed, only the NPV criterion can always provide the correct answer to both
questions
• NPV is always just the difference between market value of an assets or project and its costs, and
• The financial manager acts in the shareholders’ best interest by identifying and taking positive NPV projects
• NPV has to be estimated, it cannot be observed in the market. Therefore, it is possible to make an estimation
error. Due to this possibility, finance managers use multiple criteria to examine a project
• Other criteria provide additional information about whether a project truly has a positive NPV
End