Introduction to Capital Budgeting

Financial Modeling in Excel

Nick Edwards

Analyst at Mynd

What is capital budgeting?

• Capital budgeting is the process of allocating money to new projects that generate cash flows.
• Prioritize mutually exclusive projects

¹ https://www.investopedia.com/terms/c/capitalbudgeting.asp

Net present value (NPV)

• Net present value (NPV) is the sum of all present value cash flows.

• Invest if NPV > 0

¹ https://www.investopedia.com/terms/n/npv.asp

Net present value (NPV)

Example: Should a company invest in this project at a 10% discount rate?

Net present value (NPV)

Example: Should a company invest in this project at a 10% discount rate?

Net present value (NPV)

Example: Should a company invest in this project at a 10% discount rate?

Where do discount rates come from?

Opportunity cost

• The next best alternative result that was given up to pursue the project
• i.e. stocks, bonds, other investments

Cost of capital

• The cost of raising money for the project
• i.e. Issuing stocks or borrowing debt

¹ https://www.investopedia.com/terms/c/costofcapital.asp

Testing the IRR

Testing the IRR

Testing the IRR

Using IRR in capital budgeting

• Multiple projects: the project with the higher IRR should be selected.
• Benchmark rate: IRR must be higher than the target return.

The Golden Rule

Always choose the project with the highest positive NPV.

• NPV represents a real dollar amount

Let's practice!

Financial Modeling in Excel