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

2. 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”

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 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)
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

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
Internal Rate of Return
Definition
The average return associated with given cash flows;
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

11. 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

12. 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.

13. 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

14. 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) ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
CUBIC Fundamentals of Finance

15. 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%

16. 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%

17. 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.

18. 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”

19. 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

20. 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

21. 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%

22. 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

23. 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%

24. 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

25. 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

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

27. 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

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

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