in this video we'll go over the main capital budgeting techniques which are the npv the
irr and the payback period and alongside learning the theory we'll practice using relevant examples
on excel so let's get into it firstly what is capital budgeting and in short it's a process
a company takes to determine whether to accept or reject a project these projects are usually large
investments like building out a new factory opening a store or creating a new product and
typically this process is conducted by the financial planning and analysis team within
a company as for what's the goal here it's simply to maximize the profitability of the business and
enhance shareholder value looking at the npv first and the net present value tells us how valuable
a project is going to be the general rule here is that if the mpv of a project is greater than zero
then it should be accepted that said if the company has multiple projects with a positive npv
but it doesn't have the funds to invest in all of them then it should only prioritize
on the ones that have the highest npv to show you an example let's suppose we're working at
nike in their financial planning and analysis team and the sales team is asking to open up
two new nike stores and so our manager would like to know if that's a financially viable decision
for that we're gonna have to use capital budgeting techniques to determine it and here's the excel
file you'll be working with you can download it in the description so over here you can see the
different cache inflows and the cache outflows firstly you're gonna have a big cash outflow that
might be for acquiring the the property or maybe doing the different renovations for it and you can
see we've got two projects the first one up here and the second one just below it as you can see
the second one is only a cash outflow initially of 250 000 while the first one is a lot bigger at
1.5 million from there you're gonna start to have some cash inflows hopefully as the word spreads
that this store is now open there's gonna be more and more sales for it same thing down
below as you can see there's some cash outflows throughout they're gonna be fairly constant
this could have to do with the maintenance of the property paying salaries etc now that we know the
cash inflows and the cash outflows we can go ahead and calculate the net cash flow which is simply
going to be equals to the cash inflow plus the cash outflow because it's already in negatives
from there we can just drag that along then we're just going to copy that whole thing so ctrl c
then we're going to drag it down over here and the formula should update dynamically such that
it's related to project 2 there just like so at this point you might be tempted to just go ahead
and get all the net cash flows and sum them and that's going to give you the net present value but
unfortunately that's not entirely accurate that's because of this concept in finance called the time
value of money which basically says that a dollar today is worth more than a dollar in the future
because if you have it today you can go ahead and invest it and hopefully grow it over time
so to discount all these cash flows from year one to year five which are going to be in the future
we need to discount them using a discount rate that's going to bring it back to the present value
and for this we're going to be using this 8 which is basically the required rate of return
for the company with this information let's go ahead and calculate the mpv
so we'll go down over here equals npv that's gonna be the formula we'll be using and here you can see
the explanation for it press the tab key once you find it the rate like we mentioned is this
comma and then the value is gonna be from year one to year five close those brackets
and then you're gonna do a plus a year 0 which is going to be this net cash flow and hit enter
now at this point you might be wondering well why did you not put everything inside this formula
why did you add it in the end here and the reason for it is that the mpv starts counting in year one
and so if we put everything from all the way from over here then that would mean that it's counting
for year zero as year one and so all of the values would be distorted which wouldn't be right
all right so we've got a positive npv now what does that mean basically means that this project
is going to add value to the company and therefore it should be pursued so let's go ahead and copy
this formula and drag it all the way down to the project 2 and just paste it over here as well
double click on it to make sure that the right things are linked just like so and as you can
see this one is going to have a smaller mpv than the other one now unfortunately the npv does come
with some limitations one of the main ones is the size of the project in this case if we compare the
two projects the first one is over a million in investment and so that's why the mpv is actually
a lot greater in this one over here where it's only 250 000 and so the mpv is going to be a lot
smaller so it doesn't really account for scale very well even though the second one may have a
better return percentage-wise the other limitation is the assumption we make for the discount rate
depending on what rate we pick here like say i put a seven percent as you can see the mpv
is actually gonna vary quite a bit same thing if i put a nine percent now it's dropped all the way to
five figures so if you put it back to eight this is what it looks like usually when you assess
whether a project is worth pursuing you don't just want to know the dollar amount of the project you
also want to see the percentage return that's when the irr also known as the internal rate of return
comes handy in technical terms the irr is the discount rate that results in an npv
of 0. the general rule here is that if the irr is greater than the cost of capital or to this
country then you accept the project let's open to excel to apply it it's just going to be equals to
the irr press the top key and the values are going to be all of the cash flows over here so go ahead
and ctrl shift and then right key and that's going to select all of them hit enter that should give
you around 10.38 ctrl c to copy that and then let's just paste it down over here and ctrl v
as you can see though this time even though the mpv is greater in project one it has a lower irr
than this one over here but that being said both of them should be approved based on this
as they're higher than the discount rate or the cost of capital now suppose these two projects
are mutually exclusive meaning that the company can only afford to do one or the other in that
scenario as you can see it's a bit confusing here because you've got a higher mpv for the first one
but you've got a higher irr for the second one and so which one should you prioritize here
and generally you prioritize the higher mpv as that's the one that's maximizing shareholder
value the most as for the limitations of the irr method among the more obvious ones
is that it doesn't give you a dollar value of the project also sometimes the cash flows of a project
aren't very linear for example you might have a net cash flow that's negative in year zero
and another one that's negative in year three as there's a renovation or something like that and if
you're liking this video you can also check out our course where an investment banker financial
analyst and myself teach everything we know about finance valuation and financial modeling on excel
first we cover financial statement analysis using apple's real annual report as an example
then we get into financial modeling through a three statement model after that we begin the
valuation phase where you learn to do a discounted cash flow a comparable company's valuation and a
present transactions valuation on adobe looking at the real financial statements to eventually
derive a valuation range lastly we'll show you how to present an investment thesis using a stock
pitch format so if you're interested in checking it out go to the link in the description below
where you'll find the discount code alright back to the video next up we have the payback period
and this is simply how long it would take the company to recover its initial investment so
basically the time for the project to pay back for itself generally the shorter it takes the
better but there's no strict maximum rule for this one it very much depends on the company
and their financial position hopping on to excel to calculate the payback period firstly we're
gonna need to calculate the cumulative cash flow that's gonna give us the payback period after that
so equals the cumulative cash flow in year zero is just equals to the net cash flow however in year
one it's equals to the cash flow of year one plus the cumulative cash flow from the previous year
and just go ahead and drag that across like so and as you can see just looking in plain sight you can
find that the payback period is probably around three point something as in year four you already
have a positive cumulative cash flow and so it's somewhere around there so for this we can manually
go ahead and go equals three plus and then to find that decimal or that three point something
we can go to absolute that's going to give us only positive values such that this value here
that we'll select is positive and we're going to divide that by the net cash flow in year 4
close those brackets and hit enter that's going to give you 3.91 years that's the time it takes us to
pay back for the investment if we want to go ahead and reformat this a bit we can go to control one
from there under custom go ahead and select this whole area so ctrl a and you're just gonna
put the number sign dot number sign twice and then we're gonna go quotations put a space and
we're going to put years close the quotations and hit ok now you can see it says 3.91 years
for project 2 it's going to be the same thing so firstly let's go ahead and copy this
and we can paste it down over here as the formulas are gonna be the same press the f2 key to verify
if they're looking good from there for the payback period here we can also just go ahead and copy it
and paste it and the reason we can just paste it here is because it's also gonna be between year
three and year four if it wasn't the case then we would have to modify it as this formula is quite
manual so press the f2 key there and so that 3 you would have to change to whatever you're seeing
and same thing goes for the the absolute here you'd have to drag that across
now there is probably a better way to do this with a formula but it's going to be quite a long one
and so that's why we didn't want to get into it one of the main limitations of the payback period
is that it doesn't account for the time value of money to combat this there is what's known as the
discounted payback period which is slightly modified that you would basically go ahead
and discount all of the net cash flows first and from there you will get the cumulative cash flow
and eventually derive a payback period that's discounted also this method doesn't consider
any profits returns etc and instead it's only focused on paying back the project investment
with all these capital budgeting calculations that we made we would be able to tell our manager to go
ahead and proceed with both stores that being said if they are mutually exclusive meaning
we can only pick one we would suggest picking the first one as it's the one that has the highest npv
comment down below if you have any questions and if you want to learn more about discounted cash
flow specifically check out this video over here or go ahead and check out our course on finance
evaluation over here hit that like hit that subscribe and i'll catch you in the next one