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

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  

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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