Principles of Capital Budgeting - Investment Decisions, Business Economics & Finance Video Lecture | Business Economics & Finance - B Com

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.
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Goodbye and have a great day.
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