Fundamentals of Finance Bob Donchez 6/30/2018 CUBIC 2014 Section 4 Fundamentals of Finance Bob Donchez CUBIC Fundamentals of Finance

Consider two business ventures with the following cash flows Consider two business ventures with the following cash flows. Which should you invest in? Guess.. Note: required return is 15% Cash Flows Venture “A” Venture “B” Cash Flow Now -10,000 -40,000 Cash Flow Year 1 6,000 10,000 Cash Flow Year 2 5,000 11,000 Cash Flow Year 3 4,000 12,000 Cash Flow Year 4 3,000 35,000 Venture “A” Venture “B”

4-0 Capital Budgeting Topics 4-1 Introduction to Capital Budgeting 4-2 Capital Budgeting Tools 4-3 Determining Relevant Cash Flows 4-4 Developing Cash Flow Projections 4-5 Case #2: Business Start-up Decision: Naturally Wrapped Food Stand

Capital Budgeting 4-1 Introduction to Capital Budgeting Allocating scarce company resources to the highest use Types of projects Replacement projects Efficiency projects New business Expand existing business Go into a new business Research and development Independent versus mutually exclusive projects

Capital Budgeting 4-1 Introduction to Capital Budgeting Decision tools: Payback (breakeven) Internal Rate of Return (IRR) Net Present Value (NPV) Comment on direction of cash flows: Positive (+) is a cash inflow Negative (-) is a cash outflow

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Definition: period of time it takes to recover the initial cost of a project—then compare to company standard Example Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Decision criteria Independent projects: Fund all projects with payback less than company standard. Mutually exclusive projects: Fund project with fastest payback less than company standard.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Advantages Simple Focus on liquidity (when initial investment is returned) Good for low cost, short term projects Disadvantages Ignores cash flows after payback period Company payback standard is arbitrary Ignores time value of money Poor for high cost, long term projects

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Definition The average return associated with given cash flows; Example Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return (IRR) Working with a calculator Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Decision Criteria: Independent projects: Fund all projects with IRR greater than company hurdle rate. Mutually exclusive projects: Fund project with highest IRR greater than company hurdle rate.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Advantages Usually similar results to NPV Considers all cash flows IRR rate can be compared to risk, cost of capital (“hurdle rate”) Disadvantages Can give multiple solutions (rare) Can be unrealistic with reinvestment assumption

Capital Budgeting 4-2 Capital Budgeting Decision Tools 6/30/2018 Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Definition NPV = PV Cash Inflows – PV Cash Outflows Example, where discount rate is 15% Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000 CUBIC Fundamentals of Finance

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Working with a calculator Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000 Discount rate = 15%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000 Discount rate = 15%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Decision Criteria Independent projects: Fund all positive projects. Mutually exclusive: Fund highest positive NPV project.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Advantages Considers all cash flows Considers time value of money, taking risk into account Disadvantages Can be hard to understand the meaning of “present values”

Capital Budgeting 4-2 Capital Budgeting Decision Tools Comparing 2 projects: Apply each decision tool and decide which project is best. Cash Flows Venture “A” Venture “B” Cash Flow Now -10,000 -40,000 Cash Flow Year 1 6,000 10,000 Cash Flow Year 2 5,000 11,000 Cash Flow Year 3 4,000 12,000 Cash Flow Year 4 3,000 35,000

What is the payback period for the following cash flows? Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 3 years 3.2 years 4 years More than 4 years

What is the IRR for the following cash flows? Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 -14.1% +11.2% +19.8% +29.4%

What is the NPV for the following cash flows (discount rate is 15%)? Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 $ -3,678 $ 2,875 $ 4,915 $ 14,587

Capital Budgeting 4-2 Capital Budgeting Decision Tools Comparing 2 projects: Apply each decision tool and decide which project is best. Criteria Venture “A” Venture “B” Decision? Best? Payback < 2 years A, B NPV $3,343 IRR 32.98%

Capital Budgeting 4-3 Determining Relevant Cash Flows Basic Principle: include all incremental (marginal) cash flows associated with the project The stand alone principle Sunk costs Opportunity costs Erosion, cannibalization Net working capital changes

Capital Budgeting 4-4 Developing Cash Flow Projections Cash flows measured over time and divided into 3 categories: Initial investment expenses Project cost Net working capital needed Annual operating cash flows OCF = EBIT + Dep – Tax Terminal year cash flows (if given a fixed project life) Salvage value recovery (after tax) Recovery of working capital

Capital Budgeting 4-6 Business Start-up Case Evaluation of proposals to fund new businesses by venture capitalists (“sharks”) on ABC show “Shark Tank”. http://www.youtube.com/watch?v=UvF7uXTe8v4 http://www.youtube.com/watch?v=g31M8WmKeqg http://www.youtube.com/watch?v=3UuFR4Y4uw8

Capital Budgeting 4-6 Business Start-up Case Tasks for Case Preparation Case Review case information case spreadsheet case questions Teams prepare and discuss case numbers Teams address case questions Class discussion Link to Case Information Link to Case Spreadsheet

Module Wrap Up: Fundamentals of Finance Resources Textbooks “Essentials of Corporate Finance”, 8th edition, by Ross, Westerfield, Jordan, McGraw Hill, 2014. (expensive text) “Finance for Non-Financial Managers”, by Siciliano, 2003, McGraw-Hill. (inexpensive paperback)

Module Wrap Up: Fundamentals of Finance Resources On-line Yahoo Finance http://finance.yahoo.com/ MSN MoneyCentral http://moneycentral.msn.com/home.asp Wall Street Journal On-line http://online.wsj.com/home-page