Capital Budgeting Lecture in 10 min. Capital Budgeting Techniques Decisions NPV Net Present Value Hello! Welcome back again to www.MBAbullshit.com. Our topic for this video is Basic Capital Budgeting, alright? Remember, you can always go back to www.MBAbullshit.com. But before we move on to this video, you should first understand Present Value and Net Present Value.
If you don’t know these two topics yet, then I suggest that you first watch my other free videos on these two topics. Okay, so let’s get right down to it. First of all, I’d like to answer the question first. “What is Capital Budgeting?” Okay? When do we say we’re Capital Budgeting, or whatever, in business school? Well, basically, it answers other questions, example you’re thinking about doing a new project for your business. Capital Budgeting is when we ask ourselves, “Is it worth it to put money or capital, also known as “capital” into this project? Is it worth it? Is it a good decision? Is it a good deal in terms of money? In terms of earning to put money in this new proposed project? It could also mean, “Is it worth it to use money to buy new machine? Have you think about how much this new machine will earn, compared to the cost of getting money to buy this machine. Or, “Is it worth putting money in a new business as a whole?” Maybe you are thinking of putting up a brand new whole business. Or maybe you are thinking of buying an existing business.
Is it worth it to put money in this business? Or pay money for this business? As an example, let’s look at a valuing a project. This is just a simple example. Now let’s say that you are thinking of borrowing one thousand dollars from the bank which charges five percent interest rate so that you can buy a new machine for one thousand dollars. Let’s pretend that this machine will earn you two hundred sixty dollars for two years. And let’s say that you can only use it for two years because after two years, it’s going to breakdown. But you can sell it for scrap at five hundred dollars in the end after the two years. So my question is, “Will you win or will you lose money in this new project or in this new machine?” It doesn’t matter if it’s a machine or a project or both, okay? Will you win or lose money in this project? Now, if you look at two hundred sixty dollars for two years that’s like five hundred twenty dollars plus you earn five hundred dollars, you have one thousand twenty. One thousand twenty is higher than one thousand dollars so maybe you think that you will earn money from this project.
However, it is not as simple as that. Because remember, the concept of time value of money, future value of money and present value of money. So if you want to find out, if this is a good deal or not, we should first find out the sum of the present values of both the cash outflow and cash inflows. We first look at the present values of these. When we do that, the formula as you remember from the present value formula, will look something like this. Don’t panic. Where did we get this? This one thousand dollars is just the same as the one thousand dollars that you are paying for the machine. This point zero five is just the same as the five percent interest rate that you are paying in the bank. This two hundred sixty dollars here is just the same as the two hundred sixty dollars earnings that you’ll get and it happens for two years.
This negative one is the two hundred sixty dollars represents the going back one year to the present value of the first two hundred sixty dollars and this negative two power over here represents the two years; one, two that this two hundred sixty dollars will go back. So that we can find out the present value and this five hundred dollars over here represents the five hundred dollars you earned at the end of two years when you sell the whole machine. Alright? Simple as that.
But before we move on, I have a reminder: In more advanced problems, we will use the WACC, the Weighted Average Cost of Capital, instead of the bank interest rate in five percent, okay? But this is just a very simple example so I’ll just use the bank interest rate. And also, in more advanced problems, we will include other factors such as horizon value and growth rate, etc. Don’t worry if you don’t understand these things right now because it is not needed for this basic example or for this basic problem. So now we have this. If we move on to the other slide, here it is, exactly the same.
Remember, this negative zero over here is because this negative one thousand dollars is the one thousand dollars that you are paying today. If you are paying it today, you are bringing it back, not one year but you are bringing it back zero years because it is today, alright? So, now if we add this all up and multiply this all together, we will come up with this negative sixty three dollars as the present value of this project, of this machine, after we borrowed money to buy it and after we earned money from it. This means this project is worth a negative sixty three dollars or you will lose sixty three dollars if you do this project. So therefore, don’t do it. Okay? However, if it was a positive number then in that case you would earn money. Therefore, you should do the project.
But in our case it’s negative so don’t do it, alright? So now you understand the basic concept so you can move on to our next video, if you like, on Capital Budgeting: Valuing a Business. Remember to share it if you like it on twitter, my name is @MBAbullshit. Or please share my YouTube link on your Facebook or on your email to your friends. Goodbye and have a great day. debbierojonan Page 1.
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