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