FIN 501 Module 3 Case

Module 3 - Home

CASH FLOW ESTIMATION AND CAPITAL BUDGETING

Modular Learning Outcomes

Upon successful completion of this module, the student will be able to satisfy the following outcomes:

· Case

· Compute a project’s cash flows.

· SLP

· Apply various capital budgeting methodologies including net present value and the internal rate of return.

· Discussion

· Compare and contrast various measurements.

Module Overview

This module will introduce you to cash flow estimation and capital budgeting. 

Module 3 - Background

CASH FLOW ESTIMATION AND CAPITAL BUDGETING

Capital Budgeting Podcast (2014).  Pearson Learning Solutions, New York, NY.

Capital Budgeting Interactive Video. (2014).  Pearson Learning Solutions, New York,

As a financial manager, you are to focus on maximizing shareholder wealth.  You do that by accepting positive NPV projects and rejecting negative NPV projects.  In order to run a NPV calculation, you need cash flows which need to be estimated. 

There are several steps to estimate a project’s cash flows.

First, some assumptions need to be made regarding how many units of the goods are to be sold and at what price per unit.  The tax rate will also need to be determined. 

Second, depreciation needs to be calculated.  You need to decide which depreciation methodology you will use such as straight-line depreciation or MACRS. 

Third, you need to calculate the salvage value on the property and/or equipment that is disposed of at the end of the project’s life. 

Fourth, you can now proceed to put things together and estimate the project’s cash flows:

At Time 0 (today), you are likely to have the following cash outflows:

Building and/or equipment

Increase in net working capital

= total investment outlays (negative value) 

At Time 1 through Time N (the end of the project’s life), you are likely to have the following cash flows each year:

Sales revenue (units sold x sales price)

- Variable costs (usually some percentage of the sales revenue)

- Fixed operating costs

- Depreciation

= EBIT (earnings before interest and taxes)

-Taxes on the operating income

= NOPAT (net operating profit after taxes)

+ Depreciation add-back

= Operating cash flow 

Then at Time N (the end of the project’s life), you have terminal year cash flows likely consisting of the following:

+ Return of the net working capital

+ net salvage value

= Total terminal cash flows 

The project cash flows can finally be determined by adding together for the appropriate year the total investment outlays, the operating cash flows, and the total terminal cash flows. 

Now that you have the project cash flows, you can apply the various capital budgeting methodologies including net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), regular payback period, and the discounted payback period. 

Many of these can be calculated with Excel.

=NPV calculates a project’s NPV in Excel.

=IRR calculates a project’s IRR in Excel.

=MIRR calculates a project’s MIRR in Excel 

Review this video that focuses on NPV:

JohnFinance (2014). Net Present Value. Retrieved June 2014 from http://www.youtube.com/watch?v=GiNG9Va00fI

NPV is the best out of all the capital budgeting methodologies.  It takes into all of a project’s cash flows, it uses the time value of money, doesn’t have problems with non-normal cash flows like IRR can have when it can result in multiple IRRs, assumes reinvestment of the cash flows at the more conservative cost of capital instead of the higher less realistic IRR reinvestment rate assumption, gives consistent results with mutually exclusive and independent projects. 

Optional Resources

Bookboon.com. (2008). Corporate Finance. Retrieved from http://bookboon.com/en/economics-and-finance-ebooks  

Welch, Ivo. (2014). Corporate Finance (3rd Ed.). Chpts 4 and 12. Retrieved from http://book.ivo-welch.info/ed3/toc.html