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8/7/2019 Capital Budgeting- 30 Jan 2011 [Compatibility Mode]
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CHAPTER
CapitalCapitalCapitalCapital
TechniquesTechniques TechniquesTechniques
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WHAT IS C APITAL BUDGETING?
The process of planning and evaluating
expenditures on assets whose cash flowsare expected to extend beyond one year
Analysis of potential additions to fixed assets
Long-term decisions; involve largeexpenditures
Very important to firm’s future
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GENERATING IDEAS FOR C APITAL
PROJECTS
A firm’s growth and its ability to remain
competitive depend on a constant flow of ideas for new products, ways to make
existing products better, and ways to
produce output at a lower cost.Procedures must be established for
evaluating the worth of such projects.
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PROJECT CLASSIFICATIONS Replacement Decisions: whether to purchase
capital assets to take the place of existing assets to
maintain or improve existing operations Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
ex s ng opera ons Independent Projects: Projects whose cash flows
are not affected by decisions made about other
projects
Mutually Exclusive Projects: A set of projects
where the acceptance of one project means the others
cannot be accepted
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Determine the cost, or purchase price, of the asset.
Estimate the cash flows expected from the project.
Assess the riskiness of cash flows.
Compute the present value of the expected cash flows
SIMILARITIES BETWEEN C APITAL
BUDGETING AND A SSET V ALUATION
to obtain as estimate of the asset’s value to the firm. Compare the present value of the future expected cash
flows with the initial investment.
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CAPITAL BUDGETING
Purpose
Expansion
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Improvement
Replacement
R & D
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THE B ASICS OF C APITAL
BUDGETING
Should we
u t splant?
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IDEAL SELECTION METHOD
Will:-
Select the project that maximises shareholderswealth
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Discount the cash flows at the appropriatemarket determined opportunity cost of capital
Will allow managers to consider each projectindependently from all others
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C APITAL BUDGETING PROCESS
1. Estimate the cash flows.
2. Assess the riskiness of the cash
flows.
. e erm ne e appropr a ediscount rate.
4. Find the PV of the expected cash
flows.5. Accept the project if PV of inflows
> costs.
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SELECTION METHODS
Payback
Internal Rate of Return (IRR)
1 0
Net Present Value (NPV)
Profitability Index
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P AYBACK PERIOD
FORMULA:-
For a project with equal annual receipts:
Years 0 1 2 3 4 5
Project A 1,000,000 250,000 250,000 250,000 250,000 250,000
Where: I= initial investmentC =net annual cash inflow
Example 1:
= 4 years
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INTERNAL RATE OF RETURN
The IRR is the discount rate at which the NPVfor a project equals zero. This rate means that
the present value of the cash inflows for the
outflows.
The IRR is the break-even discount rate.
The IRR is found by trial and error.
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NET PRESENT V ALUE METHOD
Discount cash inflows to their present
value and then compare with capitaloutlay required by the investment
Discount rate (hurdle rate or requiredrate of return) - required minimum rate of
1 3
return given riskiness of investmentProposal is acceptable when NPV is ≥ zero
The higher the NPV, the more attractivethe investment
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NET PRESENT V ALUE
DECISION RULE: Invest
in capital assets?
Is NPV positive?
Invest
Is NPV negative?
Do not invest
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.
PROFITABILITY INDEX (PI)
The profitability index, or PI, method compares thepresent value of future cash inflows with the initialinvestment on a relative basis. Therefore, the PI is theratio of the present value of cash flows (PVCF) to the
.
In this method, a project with a PI greater than 1 isaccepted, but a project is rejected when its PI is lessthan 1
PI= PVCF/Initial Investment
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COMPARISON OF C APITAL
BUDGETING MODELS
Method Strengths Weaknesses
Pa back Eas to understand I nores rofitabilit
Based on cash flows
Highlights risks
and the time valueof money
NPV &IRR
Based on cashflows, profitability &
time value of money
Difficult todetermine
discount rate