Capital Budgeting

Question 1

NPV Calculation

Answer 1

NPV=Summation of (Expected Cash Flow at that time)/(1+r)^(years from present)

Question 2

IRR
Why it matters?

Answer 2

It’s the rate that sets NPV=0
If IRR>cost of capital, can borrow and gradually pay off loan-> still have money left over

Question 3

Why is IRR useful?

Answer 3

-IRR tells you how high the cost of capital can go before the project becomes unprofitable, useful supplement to NPV
-For people who understand returns but struggle with PV, tells you roughly the return on each dollar invested

Question 4

Pitfalls of IRR

Answer 4

-Ignores scale because it’s just a percent
-IRR is not actual return, assume reinvestment rate is cost of capital, not complete reinvestment
=IRR may not exist or might have multiple is cash flows change signs more than once

Question 5

Free Cash Flows Equation

Answer 5

-CF(using EBIT(t))=(1-tau)(Rev(t)-Costs(t)-DEPR(t))+DEPR(t)-CAPEX(t)-ΔWC(t)

where EBIT = (Rev(t)-Costs(t)-DEPR(t))

-CF(using EBIDTA(t))=(1-tau)(REV(t)-Cost(t))+tau*DEPR(t)-CAPEX(t)-ΔWC(t)

where EBITDA = (REV(t)-Cost(t))
and Tax Shield = tau*DEPR(t)

Question 6

After-cash cash flow from asset sale

Answer 6

CF=tau(sale price-Book Value)

where BV=amount of purchase price not yet depreciated

Question 7

Profitability Index
Why it matters?

Answer 7

PI=NPV/(Resource Consumed)
Calculates bang for your buck, don’t necessarily want to pick projects simply in order of decreasing NPV

-Caveat, for non-profits PI=(impact metric)/(resources used)

Question 8

Payback Period (and types)

Answer 8

-Payback period-# of periods for undiscounted cash flows to pay back initial investment
-Discounted payback period-same but with discounted cash flows

Question 9

Working Capital

Answer 9

WC=Current Assets-Current Liabilities