Hi there. We start now the sessions of Capital Budget.

Before we start the concept or discussion,

let's just recall where we are in the framework.

Take a look at the highlighted box.

In this video, we'll have an overview on the topics regarding Capital Budget.

And, this budget is related to the company's physical assets.

So, we're talking about supporting decisions on purchasing,

leasing, upgrading or even disinvest in fixed assets.

Analyzing and selecting assets is one of the most important decisions.

It relates to the long term viability of the company.

Of course, it's possible that the sum of requests

will surpass the available funding to approve our projects.

Therefore, a priority ranking criteria should be in place to answer the question,

which projects should we approved?

We have different methods to answer this question.

For example, we have payback analysis,

we have the net present value,

the NPV, and we have the bottleneck analysis.

Let's go into more details on each of them.

Payback, this is the simplest method and because of this,

it's not very accurate.

However, its simplicity is good to support a straightforward analysis on the projects.

The core idea of payback is to estimate the time necessary to recover the investment.

How can we do it?

Well, we could use an average time horizon calculation by dividing

the total investment by the estimated cash flow of the project for the time horizon.

But there is a disadvantage of doing so.

Should our project have a long time horizon,

the estimation of cash flow will be more inaccurate.

An improve at payback method can be applied to avoid this inaccuracy.

We just add the cash flows of each periods to the initial investment.

The payback time will occur within the period when the addition becomes positive.

Look at this table here.

We can see in the table that the net cash becomes positive within the year five.

That means, the company will recover the investments

somewhere in the fifth year after the original investment.

At this point, you may be wondering,

"But Nelson, what about the value of the money in time?"

And I would say, "Yes sure,

that's precisely the disadvantage of payback method."

And, to mitigate this advantage,

we apply the net present value.

In the NPV method,

we project the cash outflows regarding

the investment and also the cash inflows originated by the project.

We apply a discount rate on the resulting cash flow and doing so,

we have the net present value of the project.

How is the NPV calculated?

We apply this formula here,

where R is the discount rate and CF stands for cash flow for periods 1,

2 and so on.

But what's the discount rate?

Its the interest rates that we consider as

a reference to evaluate attractiveness of the project.

In other words, it's the interest rate

below which managers would disapprove the projects.

Unless, they have a clear guidance from the board of the company to go ahead.

Then let's use Microsoft Excel to calculate

the NPV for five years at a discount rate of 10% per year.

Here is the table.

We can see that applying NPV method,

the conclusion is that the project shouldn't be approved because NPV is negative.

And negative NPV for the period means that at 10% discount rate,

the project doesn't bring enough value in five years.

The example we just saw is simple.

A common investment project would have a more complicated cash outflows and inflows.

For instance, the cash outflows would probably occur in more than one period.

The company would probably have to pay for warranties, delivery setup, insurance.

New assets in the plant --may bring

efficient effect and they might generate expenses' reductions.

Should the new assets operate in a more efficient level then,

inventory levels may be lowered which would reduce working capital level.

Well, in a nutshell,

we should look for any change in the operations that the new assets may generate.

Now, let's move on.

You might be wondering,

would it be all from the budget perspective?

Well, from the budget perspective, maybe, not yet.

Imagine that you would decide the project's ranking based on the NPV.

Would you rely 100% on this method?

If you answered yes to this question, hold on.

There's more to consider.

But maybe, this matter should be discussed in the next video.

Follow through the steps,

stay tuned and see you soon.