Lecture Notes 10/23/00 Capital Budgeting/Financial Planning
There are many ways of evaluating Capital Budgets. The three methods used most often are:
1.) Net Present Value (NPV) also called Discounted Cash Flow (DCF)
 The result of NPV/DCF method is a dollar ($) amount, which can be converted into a
change in stock price. For financial purposes this is the method used most because the
over riding criteria in finance is to maximize stock price.
2.) Internal Rate of Return (IRR)
 The IRR method result with a number that is percentage (%) on return.
3.) Payback Method
 The result of the payback method is a date that represents the breakeven point, or in
other words, how long it takes to get the money back that was invested.
All three of these methods are useful because the results of each method give a different piece of information
that is helpful in making a financial decision. It should also be noted that an investment that is favorable
under on method might not be favorable under another method.
The NPV/DCF method:
In order to compute the NPV/DCF you need the estimated cash flows of a project. It should be noted that
these cash flows are incremental and only look at real cash flows. In other words, look at marginal costs - those cost that only happen between two different options. For example, if currently a company has a cash
flow of $3 million dollars but if the company decides to do Project A its cash flow will change to $4 million,
then the real cash flow or marginal cost is $1 million dollars. Note - - do NOT put financing costs into the
cash flow. Financing costs are a real negative cash flow but dealt with at a different point.
When using the NPV/DCF method you need 5 years of estimated cash flow (in industry 10 years is the norm,
but for finance class we use 5 years). Also note that a cash flow for year 0 is for that year only and cash flow
for year 1 is for year 1 only, it is not the difference from year to year.
Another piece of the NPV/DCF is the corporate discount rate (different from the Fed Discount Rate). There
are two parts to the discount rate:
1.) Cost of Capital (is the risk free rate)
2.) Risk Premium
To determine the discount rate you should determine the discount factors for each of the 5 years of estimate
cash flows. To determine the discount factor - - (1-k)^-n
For example if given a discount rate of 13.5% and cash flows
($000)
YRO
-220
YR1
90
YR2
100
The discount factor for YR0 = (1+.135)^-0 = 1
YR1 = (1+.135)^-1 = .881
YR2 = (1+.135)^-2 = .776
ETC.
End of lecture notes for 10/23/00 will continue 10/25/00
Copyright Kelley Dahlquist 10/00
YR3
110
YR4
120
YR5
130
Copyright Kelley Dahlquist 10/00