CAPITAL BUDGETING

Capital Budgeting

Capital Budgeting

The net present value of an investment is:

the value an investment must represent today

on a discounted cash-flow basis

to make an investment worthwhile after taking into account the cost of the investment

Discounted cash flow numbers are arrived at by estimating the cash flows in your future scenario, and adjusting them to a value they represent today based on some predefined discount rate. The NPV is the sum of the discounted cash flows minus the cost of the investment. If the NPV is positive, the investment is worth taking on because it is essentially the same as receiving a cash payment equal to the NPV.

Conversely, if the NPV is negative, taking on the investment dilutes the firm's value and should be rejected. But first, let's discuss how to arrive at appropriate discount rates and calculate a firm's Weighted Average Cost of Capital (WACC).

What is the appropriate discount rate?

The choice of discount rate to use in your NPV analysis can have serious impact on results and there are several different ways to arrive at an appropriate discount rate. As a general rule, you should use a discount rate that matches the way in which your firm is financed. If a firm were entirely financed with equity, the most appropriate discount rate to use would be the required return to equity required by shareholders. A more realistic notion is that the firm in question is financed with some allocation of debt and equity, in which case using the firm's WACC is most appropriate.

Weighted Average Cost of capital

You can calculate the WACC if you have the firm's equity and debt market values, the cost of equity, the cost of debt, and the firm's corporate tax rate. If your competitors are public companies, this information is in their public financial statements. (Lin, 2000) If ...