Welcome back. Once again, in this lesson, we're gonna walk through the mechanics of preparing a capital budget. And along the way, I'm gonna highlight the areas that are most often confused. The first point of confusion is that sometimes analysts try to mix the capital budgeting decision with the financing decision. So let's clarify that stage one is to first consider answering the question about whether the opportunity itself is a good idea. In other words, will it deliver returns that meet or exceed the cost of capital?

If your answer is yes, only then do you move on to stage two to evaluate how you finance the opportunity? stage two deals with the most optimal way to finance the opportunity. We will get to that in a moment when we talk about lease versus buy analysis. So if you've modeled the income statement to this point, you will begin your calculations With incremental eba earnings before interest, taxes, depreciation, and amortization, in other words, the incremental revenues less the incremental expenses associated with the opportunity, which will include your startup costs. These are commonly called relevant revenues and relevant costs. For capital budgeting purposes, you will need to back off any sunk costs that have already been incurred.

Those costs that have already been occurred are not relevant to the capital budgeting decision, and this drives the accountants nuts, but in the finance world, we only look forward. What has been spent is water under the bridge. However, in the finance world, we also consider opportunity costs, which are something that the accountants tend to ignore. And opportunity cost arises when we have an alternative purpose. For the existing assets. For example, if we have to forego some of the production of an existing product in order to produce this new product, then the last contribution margin from the existing product represents an opportunity cost that must be factored into the capital budget.

This gives us our pre tax cash flow from operations. Next, we have to calculate taxes. Nobody likes taxes, nobody understands them. However, they matter, your analysis must consider taxes. We subtract off our upfront capital costs and sustaining capital investment requirement next. Again, these must absolutely consider the associated tax shield if any special tax incentive programs can make a significant difference to the economics of your project.

Alternatively, some slower rate depreciation types of assets or non depreciable assets, such as land or the acquisition of shares can create a huge drag on returns. Lastly, we calculate our required investment in working capital to arrive at our after tax discretionary cash flows. This is notionally the cash available to serve as debt and provide a return for shareholders. We'll come back to the discussion of terminal value later. At this point, you can calculate your discount factor using the discount rate we discussed in the last lesson. Alternatively, you can use Excel to perform these calculations for you.

While the calculations are seemingly straightforward, there are some nuances that many people ignore or in fact unaware of. For example, if you use the NPV function of Excel, you need to Realize that Excel sees each column of numbers as one year. And within that column Excel assumes that the cash flow occurs at the end of the year. So consider the potential flaws in this simplistic assumption. First of all, the upfront cash flow to invest in the project typically arise at inception, whether it's to buy new equipment or to invest in inventory. These are cash flows that don't typically happen at the end of year one, but instead at the beginning.

The second issue is that operating cash flow typically doesn't happen at the end of the year, unless you are say a retailer with a heavy skew towards say the the holiday shopping season. For many other businesses, cash flows accrue evenly throughout the year. So discounting them as if they happen at the end of the year is actually penalizing your capital budget. There are two ways around this. The first is to use a good old fashioned present value formula to calculate the discount factor. Note that n in this situation would read 1.5 instead of two for the second year of operating cash flows to account for the mid year discounting.

The other approach is to use another lesser known Excel function called x NPV. This function allows you to attach dates to the cash flows and calculate your net present value this way, either way, you can sometimes see a significant bump in your expected return. In this case, notice that it added $10 to our NPV, nearly doubling it. Lastly, we haven't yet talked about the forecast horizon. There are generally two types of opportunities those within assumed indefinite life and those that finite that is only lasts for a limited number of years. So for example, I would often be modeling the construction of say a new power plant with a 25 year assumed life.

Other types of investment opportunities are assumed to have an indefinite life. So for example, when you acquire another business as a retailer or a manufacturer, there's a general assumption that these businesses will continue on forever. Now, obviously, it's important to validate this assumption as it has a huge impact on value. Take a look at your screen $148 of the hundred and $87 of value comes from the terminal value calculation. Almost every capital budget I see puts very little thought into this assumption. Once again, if a business is assumed to last forever, but really only last, say 15 years, the result of that poor capital decision won't manifest itself for 50 years when the assumption of forever is present.

Very often when we prepare capital budgets, we will use what is called a terminal value. Now, a terminal value typically capitalizes that last year of cash flow and assumes that it goes on and on and on forever. And it does this by taking that last year of cash flow and dividing it by the discount factor. Now in practice, you'll often see analysts make a prediction of the perpetual growth rate as well, which gets subtracted from the discount rate in the denominator of this formula. And the effect of doing this is it makes the denominator even smaller and the terminal value bigger. Be very cautious about this assumption.

Every business has a period of high growth, and in fairness, this can last for a number of years consider Apple as a recent example. However, sustaining that rate of growth forever is a highly unlikely consider Microsoft which hit its wall back around 2000. Once you're in that maturity stage, a growth rate beyond GDP growth becomes more difficult to support. Now one last comment on the terminal value calculation is that if we are assuming your business is gonna last forever, then you also need to consider the amount of sustaining capital required to maintain that level of cashflow. Almost all businesses need sustaining capex to maintain their plant and to develop new products to replace the old products. So a capital budget that ignores this assumption is conceptually flawed.

For finite projects, knowing the economic life of the project is a key assumption. You can build a model for the economic life of the project or you can incorporate annuity based formulas to determine present value and shortcut the calculations a little. So how many years should you prepare and include In your forecast, to be honest, in my opinion, the more the better because I don't like having a terminal value dictate the decision. The more years you're able to forecast the less the terminal value matters. So for my power plants, I just pull all the cells in Excel 25 columns to the right and eliminate the issue of calculating a terminal value all together. Now in practice, hardly anyone does this.

The practical and theoretically justifiable answer is that you should forecast as many years as it takes for the company to reach maturity. Most businesses can be characterized as having that growth phase and the maturity phase. The growth phase has uneven cash flows as incremental capital needs to be invested to build capacity. However, once the business is mature, the cash flows kind of level up and our terminal value shortcut that we discussed should and theory and in practice, hold water. So there you have it. Yeah.

Add up your discounted cash flows to arrive at net present value. And we should all appreciate that a positive number implies that the cash flows generated by pursuing the investment opportunity exceed our cost of capital. The amount of NPV theoretically represents the positive amount of shareholder value created. These are the economic profits, in other words, those that are above and beyond the normal profits associated with running the business. Now a business can be generating and accounting profit, but an economic loss if the opportunity fails to generate returns that meet the shareholders expectations. Let's spend a moment talking about a few other measures that are helpful for making capital budgeting decisions that should be incorporated into your capital budgeting model.

An internal rate of return represents the discount rate at which the NPV equals zero if an internal rate of change Turn exceeds our cost of capital, then we should have a positive NPV. My earlier comment about watching for Meteor discounting applies here as well. And the easiest and only way around this in Excel is to use the ex IRR function, which once again allows you to attach a date to each cash flow. Now a common rule of thumb for many entrepreneurs is payback. How long does it take for an investment opportunity to return my initial capital investment? There's no economic justification for the use of this method.

But still, its simplicity holds a certain appeal for those businesses that are winging their investment analysis. And I'll admit, even in the utility business, we calculated payback, and we use a seven year threshold for any unregulated opportunities as one of our evaluation criteria. So in our capital budget presented here, we haven't forecasted enough years to calculate simple payback capital budgeting is as much about comparing one opportunity as it is comparing different and competing opportunities. Every organization should have a portfolio of opportunities that it's measuring and monitoring. Remember my Nova Scotia gas utility example and the 20 other competing opportunities against it. Preparing a one off capital budget for one particular opportunity is a very narrow view of strategic management.

And it's typically done to justify someone's prerogative to spend some money. If you're going to be a strategist leader in your organization, challenge all of your business unit leaders take keep an ongoing list of opportunities. This is the essence of capital allocation. capital allocation is allocating a company's scarce resources to the highest yielding opportunities that they see across the organization. If decisions about capital investment are made in isolation of one another, there can be no assurance that capital is being allocated to the highest returning opportunity. A helpful measure to rank and prioritize different opportunities is to use the profitability index.

This measure compares the present value of net revenues to the size of the upfront investment. The higher the ratio, the more bang for your buck you're getting from one investment relative to another. Let's wrap up by reviewing three key points. In this lesson, we walked through the proper mechanics of preparing a capital budget analysis using Excel to our ROI that a net present value to calculate an internal rate of return as well as the profitability index. These metrics help us make capital investment decisions that are creative to shareholder value when compared to other competing alternatives. These metrics help us differentiate those with the highest return possibility so Secondly, we talked about how you set up your capital budget to get the timing of cash flows right, including beginning versus end versus entry your points of cash flow.

And finally, we looked at the terminal value assumption. This seemingly simplistic assumption often represents a significant amount of the total present value of many capital investment opportunities. So its calculation requires careful consideration of the assumptions. That's all for this lesson. In our next lesson, we're going to tackle how we communicate the capital budgeting analysis to the decision