Professional Documents
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Capital Budgeting
Capital Budgeting
What is finance?
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I. The Three Primary Duties of the
Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
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The Capital Budgeting Decision
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The Capital Structure Decision
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
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The Working Capital Decision
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II. The Capital Budgeting Choice: Capital
Budgeting Decision-making Criteria
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Capital Budgeting Decision-making
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Capital Budgeting Decision-making
We are considering a new gym and health plan for our
employees. We have conducted a study and affirmed that
the new gym and plan will save us $35,000 per year, in
reduced absenteeism and turnover, and will cost us
$200,000 to put into place. Should we make this investment?
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Capital Budgeting Decision-making
Thusly:
Observe the calculator application for cash flows.
Remember always to begin cash flow analyses by
hitting 2nd, CLR WORK after you hit the CF key.
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Capital Budgeting Decision-making
The NPV rule anticipates the IRR rule in Section 8.4 of your text.
The IRR is that discount rate that forces the NPV to zero. With
equal-sized cash flows or annuities, the IRR is simply the I/Y.
With irregular cash flows, we must use the CF keys to “discover”
the IRR. We “know” the IRR in the first example with even
$35,000 annual cash flows for 8 years is over 8%, as our NPV >
0. If the IRR > Required Return, then the NPV must be > 0.
Using the CF keys, IRR = 8.149% in the first example, as also I/Y =
8.149%.
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Capital Budgeting Decision-making
We examine the relationship between NPV and IRR with another
set of prospective cash flows. Suppose a project will cost us
$165,000 and throw off cash flows of $63,120 the first year, $70,800
the second and $91,080 the third. What is its IRR, and what is its
NPV at a discount rate of 16%? The graph below portrays the
NPV/IRR dynamic. The IRR occurs, of course, where the NPV = 0.
70,000
60,000
50,000
40,000
30,000
NPV
20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
-20,000
Discount Rate
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Capital Budgeting Decision-making
Advantages and disadvantages of the NPV and IRR rules
are given in your text and condensed in Table 8.6.
For the IRR rule, it is elegant, and widely used, but with
mutually exclusive projects, it can be misleading. An
example? Suppose you are choosing between two new
delivery trucks. The first costs $10,000 and provides
cash flows of $7,000 the first year, and $5,000 each of
the second and third years, yielding an IRR of 34.68%.
A second newer truck costs $20,000 and generates
cash flows of $12,000 the first year, $10,000 the second
and $8,000 the third. This represents an IRR of 25.34%
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Capital Budgeting Decision-making
• Recall the mutually exclusive decision of buying one used truck or one
newer one. The old truck generated an IRR of 34.68%, the new one an
IRR of 25.34%. But, if our cost of capital or required return is 10%, our
NPV is $4,252 for the older truck, and $5,184 for the newer one.
• We choose the newer one, maximizing our wealth (and share price,
indirectly) though it generates the lower IRR. That is a disadvantage of
the IRR rule, it breaks down with those mutually exclusive buddies.
• And, if the signs of your cash flows change more than once – if the
cash flows are “unconventional,” you cannot dependably use the IRR
rule, either. Multiple IRR’s are possible, depending on the number of
“sign changes’ attaching to a given deal.
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Capital Budgeting Decision-making
• The third rule we review is the payback rule in Section 8.2 pages 228-
232, where a deal is accepted if the payback < some required payback
period.
• With an annuity, the payback period (PP) is simply equal to the cost of
a project divided by the annual flows; using our original set of “simpler”
cash flows:
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Capital Budgeting Decision-making
• The final rule we consider is the profitability index (PI) from page 242.
The PI is simply a metric contrasting the present value of a project’s
cash flows with its costs.
• PI = PV (Inflows)/PV (Outflows)
• The PI is larger the greater a project’s IRR. For the original set of cash
flows, at a discount rate of 8%, the PV of the health plan’s cash flows
(the numerator of the PI function above) was just over $201,000. (Cost
plus the NPV). The cost or denominator was $200,000. The PI is
around 1.006. ($201,132/$200,000)
The four new rules are used in concert, by the firm and its
financial managers, to optimize the results of the capital
budgeting decision-making process.
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DEFINITION
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Objectives :
• Consider all relevant cash flows.
• Discount cash flow using the firm’s
opportunity cost of capital.
• Select the project form a set of
mutually exclusive project that
maximizes the value of firm.
• Allow each project to be evaluated
independently of all others being
considered.
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CHARECTERISTICS OF
CAPITAL BUDGETING
• It involves a current & near future outlay
of funds called “capital expenditure”.
• It is non-routine
• it is non respective.
•It is discrete with time, financial &
technical goals.
• It is essential for long term phenomenon.
•It consider flow of benefit to be yield in
future.
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Maximization of Shareholder
value & Capital budgeting
Following are the ways useful to
categorized Capital Projects :
• Cost Reduction
• Output Expansion
• Expansion by developing new
products & Market
• Government Regulation
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Methods of Capital
Budgeting
Payback Period
Method
In this method the number of years it
takes for the net cash flows to equal
the cost of projects it define as
payback period.
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Discounted Present
Value Method
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• Internal rate of return :
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Capital Budgeting Process
• Corporate goal
• Strategic planning
• Investment opportunity
• Preliminary screening
• Financial appraisal
• Qualitative factor of project evaluation
• Accept\ Reject decision
• Project implementation & monitoring
• Post Implementation audit
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the cost of capital
• The use of the net present value and
internal rate of return method requires
future cash flows be discounted by the
firm’s cost of the funds used to pay for
the cost of project
• The cost of such fund is referred to the
cost of capital
• The cost capital is the returned required
by the investors in the debt and equity
securities of the firm
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The cost of debt capital
• There is a little controversy about
the cost of capital raised by
borrowing from banks or selling
bonds that cost is the net or after tax
interest rate paid on that debt
• For a given interest rate (i) and
marginal tax rate (t), the after tax
cost of debt (d) is given by
•
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d= i (1 – t )
Cost of equity capital
There are three approaches to
estimating the cost or equity
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CONCLUSION
It is the process of planning capital
projects, raising funds & efficient.
The demand for capital function shows
the amount of capital spending that will
be made at each cost of capital.
It is a long term planning for making &
financing proposed capital outlays.
Profitability of different projects is
determined by using all the methods
which we have seen.
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