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Capital Budgeting Finance 100 Prof. Michael R. Roberts Copyright © Michael R. Roberts 1 Topic Overview How should capital be allocated? » Do I invest / launch a product / buy a building / scrap / outsource... » Should I acquire / sell / accept offer for company or division? » How should the capital budgeting process be organized? Which choices should I make? » make or buy » which distribution channel » should I test market a product Copyright © Michael R. Roberts 2 1 1 Discounted Cash Flows (DCF) A Tool for Rational Decision Making What can be an object of capital budgeting procedures? » There must be a choice - choose a base case and an alternative. (Do nothing/status quo) Identify incremental cash…show more content…
Copyright © Michael R. Roberts 11 Using the WACC to Value a Project (Cont.) What is the value of the project, including the tax shield from debt ? What is the project NPV ? Copyright © Michael R. Roberts 12 6 6 NPV Rule Synopsis Step 1: Determine the free cash flow of the investment Step 2: Compute the WACC Step 3: Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC » The WACC can be used throughout the firm as the companywide cost of capital for new investments that are: – of comparable risk to the rest of the firm, and – that will not alter the firm’s debt-equity ratio. NPV Rule: If NPV > 0, accept; if NPV < 0, reject Copyright © Michael R. Roberts 13 What Does a Positive NPV Mean? Consider a project with the following cash flows: Time 0 1 2 3 CF -100 -50 30 200 and a discount rate of 10% had an NPV of 29.6 @ 10%. So what? This project profile implies an NPV of NPV = −100 + −50 30 200 + + = 29.6 2 1.10 1.10 1.103 Copyright © Michael R. Roberts 14 7 7 What Does a Positive NPV Mean? (Cont.) Suppose the only shareholder can borrow and lend at the same rate (i.e., perfect capital markets) Year Project Cash Flow Loan Cash Flow Interest Balance of account Payment to shareholder

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