Capital BudgetingBuilding Blocks of KnowledgeWhat is this slide show about?Capital BudgetingCapital Budgeting (more)Capital Budgeting - Public SectorCapital budgeting decisions are among the most important ones made by managers and executives.ImportanceImportance (more)Importance (even more)Capital budgeting has become more effective, and more fun, during the past decade“What was once a budget exercise becomes an analysis of policy” (Peter Drucker)Steps in the Capital Budgeting ProcessMore Steps in the Capital Budgeting ProcessCapital Budgeting Decision makingIncremental Cash Flows Two RulesWorking CapitalTaxes and DepreciationIncremental Cash Flows ExampleIncremental Cash Flows Three conceptual problemsSunk CostsSunk Cost ExampleEasier said than doneOpportunity costsAn opportunity cost is a benefit lostExternalitiesExternalities (more)Summary - Economic Concepts for use in discounted cash flow analysisTime Value of MoneyExamplePowerPoint PresentationThe dilemma facing the firmCalculating the Project’s NPVDiscount rates are estimates of an organization’s cost of capitalFirm’s cost of capitalCost of capitalRiskier Projects > Higher Discount RateNPV of the Firm’s ProjectCalculating NPVMaking an Initial DecisionSpecial RuleSensitivity AnalysisDefinitionHow to do “what if”Sensitivity Analysis RoutineUsefulnessSlide 47How To Handle UncertaintySummaryCapital Budget Decision ProcessCapital BudgetingEconomic concepts and finance decision-making toolsBUS 219Building Blocks of Knowledge Time value of money – a dollar in the future is worth less than a dollar in hand nowNet present value 1. NPV = PV of cash flow benefits– Investment cost2. Accept project if NPV > $0Financial StatementsCash is kingWhat is this slide show about?Ingtegrates topics from several chapters of Corporate Finance–NPV–Discounted cash-flow analysis–Project analysisCapital Budgeting Investment decisions involving capital assets (tangible property, including durable goods, equipment, buildings, installations, land) Capital refers to the fixed assets of an organization (factories, hospitals, schools, and their major equipment fit into this category),Capital Budgeting (more)A budget is a plan which explains the projected cash flows during some future period. A capital budget is therefore an outline of planed expenditures on fixed assets, and capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budgetCapital Budgeting - Public SectorCapital budgeting is done in the public sector too, although it is not always referred to as such. Economic analysis and investment analysis are synonymous terms that one my hear. Benefit-cost analysis and cost-effectiveness analysis play an important role in the process of capital budgetingCapital budgeting decisions are among the most important ones made by managers and executives.ImportanceResults of investments in schools and hospitals continue for many years. Once these decisions are made, the organization loses some of its flexibility. Once a major piece of equipment is purchased, the organization is “locked in” to using it for the long term.Importance (more)Errors in the forecast need for big ticket assets can have serious consequences (LILCO-Shoreham) Imagine an office or hospital being built, or a school established, and then there is not enough demand to utilize the services. Conversely, what happens if not enough is spent. Inadequate capacity in a business, hospital or school can have disastrous results.Importance (even more) Timing is anotther reason that good capital budgeting is so essential. Essential assets need to be ready to come “on-line” when needed. Early arrivals cause extra expenses that will strain resources. Funding of such major projects involves very substantial expenditures. Large amounts of money are not available instantaneously in any organization, be it a large corporation, school district or the federal government.Capital budgeting has become more effective, and more fun, during the past decadeUsed to be math and manpower intensive, because the underlying theory needs a lot of calculationsNowadays, most modern organizations are able to use computers to transform data to informationCapital budgeting used to take man years of work, mostly in manual calculations. Now capital budgeting is done in hours with spreadsheets“What was once a budget exercise becomes an analysis of policy” (Peter Drucker)Steps in the Capital Budgeting Process1. Determine the economic life of the project or alternatives you are considering.2. Estimate their Incremental Cash Flows3. Determine the discount rate.4. Calculate Net Present Value5. Apply the appropriate criterion to arrive at an initial preferenceMore Steps in the Capital Budgeting Process6. Do Sensitivity & Scenario Analysis7. Interpret the results of the basic analysis and the sensitivity/scenario analysis, and make a decision. 8. If you decide to aquire the use of an asset, evaluate: lease versus buy9. Check to make sure you can afford your decision by putting it in the organization’s budget.10. Implement & Verify your decision.Capital Budgeting Decision making Concepts you must understand to be able to participate:– incremental cash flows– the time value of money and – sensitivity analysisIncremental Cash FlowsTwo RulesAnnual cash flow, and not accounting profits or costs, are to be used. Depreciation and the need for Working Capital are causes of major differences between profits and cash flow Only Incremental cash flows are relevant for evaluating investment projects. Only those cash flows that would result directly from a decision to accept a project are consideredWorking CapitalThe payroll needs to be paid before revenues from the days work are receivedWorking capital is the cash you need to pay expenses before the benefits are realizedTaxes and DepreciationTaxes are a fact of life, and need to be considered in all financial decisionsDepreciation is an expense that is not a negative cash flow; to the contrary depreciation results in a tax shield (a positive cash flow) that offsets taxes to some extentIncremental Cash Flows Example a firm considering the establishment of a branch office in a newly developing section of a city  Incremental cash flows will consist of the costs of investment and