Capital Budgeting: NPV, IRR, Payback | MUST-KNOW for Finance Roles

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

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