Module 3 – Background
CASH FLOW ESTIMATION AND CAPITAL BUDGETING
Capital Budgeting Podcast (2014). Pearson Learning Solutions, New York, NY.
Capital Budgeting Interactive Video. (2014). Pearson Learning Solutions, New York,
As a financial manager, you are to focus on maximizing shareholder wealth. You do that by accepting positive NPV projects and rejecting negative NPV projects. In order to run a NPV calculation, you need cash flows which need to be estimated.
There are several steps to estimate a project s cash flows.
First, some assumptions need to be made regarding how many units of the goods are to be sold and at what price per unit. The tax rate will also need to be determined.
Second, depreciation needs to be calculated. You need to decide which depreciation methodology you will use such as straight-line depreciation or MACRS.
Third, you need to calculate the salvage value on the property and/or equipment that is disposed of at the end of the project s life.
Fourth, you can now proceed to put things together and estimate the project s cash flows:
At Time 0 (today), you are likely to have the following cash outflows:
Building and/or equipment
Increase in net working capital
= total investment outlays (negative value)
At Time 1 through Time N (the end of the project s life), you are likely to have the following cash flows each year:
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Sales revenue (units sold x sales price)
– Variable costs (usually some percentage of the sales revenue)
– Fixed operating costs
= EBIT (earnings before interest and taxes)
-Taxes on the operating income
= NOPAT (net operating profit after taxes)
+ Depreciation add-back
= Operating cash flow
Then at Time N (the end of the project s life), you have terminal year cash flows likely consisting of the following:
+ Return of the net working capital
+ net salvage value
= Total terminal cash flows
The project cash flows can finally be determined by adding together for the appropriate year the total investment outlays, the operating cash flows, and the total terminal cash flows.
Now that you have the project cash flows, you can apply the various capital budgeting methodologies including net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), regular payback period, and the discounted payback period.
Many of these can be calculated with Excel.
=NPV calculates a project s NPV in Excel.
=IRR calculates a project s IRR in Excel.
=MIRR calculates a project s MIRR in Excel
Review this video that focuses on NPV:
JohnFinance (2014). Net Present Value. Retrieved June 2014 from http://www.youtube.com/watch v=GiNG9Va00fI