CAPITAL BUDGETTING

CHAPTER OVERVIEW:
Defined Capital Budgeting Objectives of Capital Budgeting The Capital Budgeting System Evaluation of Proposed Capital Expenditures Methods of Economic Evaluation Risk, Uncertainty and Sensitivity

 Financial Management is largely concerned with Financing, Dividend

and Investment decision of the firm with some overall goal in mind. Corporate Finance Theory has developed around a of maximizing goal the market value of the firm to its shareholders. This is also known as Shareholder Wealth Maximization.
Although various objectives or goals are possible in the field of finance,

the most widely accepted objective for the

firm is to maximize the value of the firm to its owners.

 Financing Decision deal with the firms optimal capital

structure in terms of debts and equity.

Dividend Decisions relate to the form in which returns

generated by the firm are passed on to equity-holders.

Investment Decision deal with the way funds raised in

financial markets are employed in productive activities to achieve the firms overall goal; in other words, how much should be invested and what assets should be invested in.

What is Capital Budgeting?

Capital Budgeting is primarily concerned with

sizable investments in long terms assets. Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures

Cont
Analysis of potential projects.
Long-term decisions; involve large expenditures. Very important to organizations future

Formal methods used in capital budgeting

Accounting rate of return Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Steps in Capital Budgeting

Estimate cash flows (inflows & outflows)
Assess risk of cash flows.

Determine r = WACC for project

WACC(Weighted Average Cost of Capital) is the rate that a company is expected to pay on average to all its security holders to finance its assets. r stands for required of firms debts financing
Evaluate cash flows

What is the difference between independent and mutually exclusive projects?

Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one would be adversely affected by the acceptance of the other.

The Capital Budgeting System

Capital Budgeting System is a multi faceted activity. There are several sequential stages in the process. For typical investment proposals of a large corporation, the distinctive stages in the capital budgeting process are depicted.

Strategic Planning- is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future. It translates the firms corporate goal into specific policies and directions, set priorities, specifies the structural, strategic and tactical areas of business development, and guides the planning process in the pursuit of solid objectives.

Qualitative Factors in Project Evaluation

What is the payback period?

The number of years required to recover a projects

cost,

or How long does it take to get the entitys money back?

The payback measures the length of time it takes a company to recover in cash its initial investment. This concept can also be explained as the length of time it takes the project to generate cash equal to the investment and pay the company back. It is calculated by dividing the capital investment by the net annual cash flow. If the net annual cash flow is not expected to be the same, the average of the net annual cash flows may be used.

E.g. ABC Company , the cash payback period is three years. It was calculated by dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000 inflows - $200,000 outflows)

The shorter the payback period, the sooner the company recovers its cash investment. Whether a cash payback period is good or poor depends on the company's criteria for evaluating projects. Some companies have specific guidelines for number of years, such as two years, while others simply require the payback period to be less than the asset's useful life.

Strengths of Payback: 1. Provides an indication of a projects risk and liquidity. 2. Easy to calculate and understand.

Weaknesses of Payback: 1. Ignores the Time Value of Money. 2. Ignores CFs occurring after the payback period.

Annual rate of return method

Theannual rate of return uses accrual-based net income to

calculate a project's expected profitability. The annual rate of return is compared to the company's required rate of return. If the annual rate of return is greater than the required rate of return, the project may be accepted. The higher the rate of return, the higher the project would be ranked. The annual rate of return is a percentage calculated by dividing the expected annual net income by the average investment. Average investment is usually calculated by adding the beginning and ending project book values and dividing by two.

Sample Problem
Assume the Cottage Gang has expected annual net

income of $5,572 with an investment of $150,000 and a salvage value of $5,000. This proposed project has a 7.2% annual rate of return ($5,572 net income $77,500 average investment).

 Please note that, The annual rate of return should not

be used alone in making capital budgeting decisions, as its results may be misleading. It uses accrual basis of accounting and not actual cash flows or time value of money.

Discounted Cash Flow Methods

The Net Present Value Method Internal Rate of Return Method

Note : Considering the time value of money is important when evaluating projects with different costs, different cash flows, and different service lives. Discounted cash flow techniques, such as the net present value method, consider the timing and amount of cash flows. To use the net present value method, you will need to know the cash inflows, the cash outflows, and the company's required rate of return on its investments. The required rate of return becomes the discount rate used in the net present value calculation. For the following examples, it is assumed that cash flows are received at the end of the period.

The Net Present Value Method

This valuation requires estimating the size and timing of all the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV. See also Time value of money. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV. The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment.

Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV