1. Fundamentals of Finance Tom C. Nelson, PhD
CUBIC 2012 Section 4
Fundamentals of Finance
Tom C. Nelson, PhD

2. Clicker Question (4.0)
Consider two business ventures with the following cash flows. Which should you invest in? Guess..
Note: cost of capital (discount rate) is 15%
Cash Flows
Venture “A”
Venture “B”
Cash Flow Now
-10,000
-30,000
Cash Flow Year 1
6,000
9,000
Cash Flow Year 2
5,000
15,000
Cash Flow Year 3
4,000
21,000
Cash Flow Year 4
3,000
32,000
Venture “A”
Venture “B”

3. 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 Determining Cost of Capital
4-6 Case #2: Business Start-up Decision: Naturally Wrapped Food Stand

4. 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

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

6. 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) ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000

7. 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.

8. 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

10. 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) ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000

11. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Net Present Value (NPV)
Working with a calculator
Cash Flow $
CF ,000
CF ,000
CF ,000
CF ,000
CF ,000
Discount rate = 15%

12. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Net Present Value (NPV)
Working with a spreadsheet
Cash Flow $
CF ,000
CF ,000
CF ,000
CF ,000
CF ,000
Discount rate = 15%

13. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Net Present Value (NPV)
Cash Flow $
CF ,000
CF ,000
CF ,000
CF ,000
CF ,000
Discount rate = 15%

14. 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.

15. 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”

16. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Internal Rate of Return
Definition
The average return associated with given cash flows;
The return (discount rate) that makes the NPV = 0
Example
Cash Flow $
Cash Flow Year 0 (start) ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000

17. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Internal Rate of Return (IRR)
Working with a calculator
Cash Flow $
CF ,000
CF ,000
CF ,000
CF ,000
CF ,000

18. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Internal Rate of Return (IRR)
Working with a spreadsheet
Cash Flow $
CF ,000
CF ,000
CF ,000
CF ,000
CF ,000

19. 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.

20. 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
Can conflict with NPV when projects are different sized and mutually exclusive (if so, use NPV)

21. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Comparing 2 projects: Apply each decision tool and decide which project is best. Required return = 15% for both projects.
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

22. 3 years 3.2 years 4 years More than 4 years Clicker Question (4.2.1)
What is the payback period for the following cash flows?
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

23. Clicker Question (4.2.2)
What is the NPV for the following cash flows (discount rate is 15%)?
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
$ -3,678
$ 2,875
$ 4,915
$ 14,587

24. Clicker Question (4.2.3) 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%

25. 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%

26. 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

27. 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

28. Capital Budgeting 4-5 Determining Cost of Capital
Concept of Cost of Capital
Definition and approach; weighted average cost of capital (WACC)
Purposes of cost of capital
Valuing divisions of companies
Valuing companies, both public and private
Valuing capital projects
Setting rates and returns for regulating utilities

29. Capital Budgeting 4-5 Determining Cost of Capital
Concept of Cost of Capital
Calculating WACC
1) Determine amount of debt and equity
2) Determine proportion of debt and equity
3) Determine cost of equity and after tax cost of debt
4) Calculate weighted average cost of capital

30. Capital Budgeting 4-5 Determining Cost of Capital
Calculating WACC Example
Determine amount of debt and equity
Amount of debt = $100 million
Market value of equity = $ 200 million
Determine proportion of debt and equity
Percent of debt = 100 / ( ) = .333 = 33%
Percent of equity = 200 / ( ) = .667 = 67%

31. Capital Budgeting 4-5 Determining Cost of Capital
Calculating WACC Example
Determine cost of equity and after tax cost of debt
Cost of debt = 8%, tax rate = 35%
Cost of debt = 8 x ( ) = 5%
Beta = 2.0; risk-free rate = 3%; market return = 10%
Cost of equity (CAPM) = 3 + (10 – 3)(2) = 17%

32. Capital Budgeting 4-5 Determining Cost of Capital
Calculating WACC Example: Conch Republic
4) Calculate weighted average cost of capital
WACC = (weight of debt x cost of debt) +
(weight of equity x cost of equity)
= (.33 x 5) + (.67 x 17)
= 13%

33. Capital Budgeting 4-6 Business Start-up Case
Evaluation of proposals to fund new businesses by venture capitalists (“sharks”) on ABC show “Shark Tank”.

34. 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

35. Module Wrap Up: Fundamentals of Finance
Course Objectives
• a working knowledge of the terminology of finance and
fundamental concepts and tools used in the business world;
• an understanding of the interrelationships between accounting and finance;
• an understanding of the interrelationships between business
management and a firm's financial statements;
• an introduction to financial markets, the time value of money, risk
and return, and the valuation of assets and business projects.

36. Module Wrap Up: Fundamentals of Finance
Resources
Textbooks
“Essentials of Corporate Finance”, 7th edition, by Ross, Westerfield, Jordan, McGraw Hill, 2011.
“Corporate Finance Demystified”, by Adair, McGraw Hill, 2006.
“Finance and Accounting for Non-financial Managers, by Droms, Persius Publishing, 2003

37. Module Wrap Up: Fundamentals of Finance
Resources
On-line
Yahoo Finance
MSN MoneyCentral
Wall Street Journal On-line

38. How useful were clickers to you in this module?
Clicker Question
How useful were clickers to you in this module?
A. Very useful
B. OK
C. Not very useful

39. Clicker Question
Pick the statement most true for you about the clickers as used in this module:
Helps break up the class routine
Helps me with topics/concepts
Too easy
Not helpful, shouldn’t be used