1. Capital Budgeting

2. Capital Budgeting Preliminary 2 0 1 2 3 4 5 sunk costs How do you decide whether to do a particular project or make a particular investment? How do you rank projects within your capital budget? The projects have annual cash flows, CF i What is the cash flow? What is the discount rate ?

3. Expected Project Cash Flows  Assume there are three future cash flow scenarios, A, B, and C during some future year. The expected cash flow is during that year is  The scenarios are mutually exclusive – independent  Example  CF A = $1,000,000 with probability 50%  CF B = $500,000 with probability 30%  CF C = $150,000 with probability 20%  The risk (variance) in the expected cash flow is included in the discount rate

4. State- ment of Cash Flows 4

5. Statement of Cash Flows  This financial statement details the change in the balance sheet cash and equivalents accounts, CE, during an accounting period.  CE i = CE i-1 + CFO i + CFI i + CFF i = CE i-1 + ∆CE  ∆CE = CFO + CFI + CFF  CFO is the cash flow from operating activities  CFI is the cash flow from investing activities  CFF is cash flow from financing activities 5

6. Capital Budgeting Methods  Net present value  NPV should be positive  is risk adjusted cost of capital  Internal rate of return  IRR should exceed the risk adjusted cost of capital,  (Discounted) Payback period  Time periods to breakeven 0 1 2 3 4 5 sunk costs

7. 0 1 2 Internal Rate of Return 7 260 -100 -165 Solve for the two roots of the second order polynomial. The smallest root is the internal rate of return

8. Cash Flow  Since discounting at the cost of capital, the project cash flow should be computed similarly to the firm’s free cash flow 8 Balance Sheet Assets Liability & Equity CE ‘Non-Capital’ Capital Statement of Cash Flows Net cash from operating activities From OA From NOA Net cash used by investing activities For OA For NOA Net cash from financing activities  CE CFO CFI CFF FCF CFO * CFI * Investors ∆ CE = CFO + CFI + CFF FCF = CFO * + CFI *

9. Free Cash Flow FCF = CFO * + CFI * CFO * = CFO - IDI∙(1-  ) + IX∙(1-  ) = NP + DX + ∆T –  NWC - DG - IDI∙(1-  ) + IX∙(1-  ) = (EBIT – IX)·(1 –  ) + DX + ∆T- (∆OWC -  OCE) - CS + CC - IDI∙(1-  ) + IX∙(1-  ) = (EBIT – IDI)·(1 –  ) + ∆T + DX - (CS – CC) - (∆OWC -  OCE) = NOPAT + DX - CS + CC - ∆OWC +  OCE CFI * = CFI -  IS +  OCE = -CX +  IS + CS -  IS -  OCE = - CX + CS -  OCE 9 From CFO: Remove effective non- operating cash flow and add back effective cash flow to debt providers. From CFI: Remove non-operating cash flow,  IS, and add cash needed for business operations,  OCE At Fairway at IDI and IX transactions are cash

10. Free Cash Flow 10 FCF = CFO * + CFI * = NOPAT + DX - CS + CC - ∆ OWC +  OCE - CX + CS -  OCE = NOPAT – (CX - DX – CC) - ∆ OWC = NOPAT –  NC –  OWC = NOPAT –  IC