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Seat no. B-0697044

Capital budgeting (definitions):

The process of identifying, analyzing and selecting investment projects whose

returns (cash flows) are expected to extend beyond one year. [1]

The process of evaluating and selecting long-term investments that are consistent

with the firm’s goal of maximizing owner wealth. [2]

determine whether a firm's long term investments such as new machinery,

replacement machinery, new plants, new products, and research and

development projects are worth pursuing. [3]

Capital Expenditure:

A capital expenditure is an outlay of cash for a project that is expected to

produce a cash inflow over a period of time exceeding one year. [4]

Expenditures that may provide benefits into the future and therefore are treated

as capital outlays and not as expenses of the period in which they were incurred.

[5]

An outlay of funds by the firm that is expected to produce benefits over a period

of time greater than one year. [6]

There are five steps in process.

Proposal Generation

Proposals are made at all levels within a business organization and are

reviewed by Finance personnel. [7]

purposes of analysis, projects may be classified into five categories.

2. Replacement of equipment or buildings.

3. Research and development.

4. Exploration

5. Others (for e.g., safety-related or pollution–control devices) [8]

In this step people from every field of the corporation like Marketing,

Operations, and Finance develop proposals mostly looking into their own

department first.

Formal review and analysis is performed to assess the appropriateness of

proposals and evaluate their economic viability. Once the analysis is complete, a

summary report is submitted to decision makers. [9]

cash flows for a project. The final results we obtain from our analysis are no

better than the accuracy of our cash flow estimates. Because cash, not accounting

income, is central to all decisions of the firm, we express whatever benefits we

expect from a project in terms of cash flows rather than income flows. [10]

In this step the proposals go through serious analysis about being beneficial to

what extent for the firm.

Decision Making

Firms typically delegate capital decision making on the basis of dollar

limits. Generally, the board of directors must authorized expenditures beyond a

certain amount. Often plant mangers are given authority to make decisions

necessary to keep the production line moving. [11]

Implementation

Following approval, expenditures are made and projects implemented.

Expenditures for a large project often occur in phases. [13]

Follow-up

Results are monitored and actual costs and benefits are compared with

those that were expected. Action may be required if actual outcomes differ from

projected ones. [14]

Following techniques are used for capital budgeting:

1. Payback Period

2. Internal rate of return

3. Net present value

4. Profitability index [15]

5. EAC (Equivalent Annual Cost) [16]

The first method is a simple additive method for assessing the worth of a project.

The remaining are more complicated discounted cash flow (DCF) techniques. [17]

Payback Period

The period of time required for the cumulative expected cash flows from an

investment project to equal the initial cash outflow.

The payback period (PBP) of an investment project tells us the number of years

required to recover our initial cash investment based on the project’s expected

flows. [18]

1. Accumulate the cash flows occurring after the initial outlay in a cumulative

inflows column.

2. Look at the cumulative inflows column and note the last year for which the

cumulative total does not exceed the initial outlay.

3. Compute the fraction of the following year’s cash inflows to payback the

initial cash outlay as follows:

Take the initial outlay minus the cumulative total from step 2; divide this

amount by the following year’s cash inflow.

4. To get the payback period in years, take the whole figure determined in step

2 and add to it the fraction of a year determined in step 3.

ACCEPTANCE CRITERION

If the payback period calculated is less than some maximum acceptable payback

period, the proposal is accepted; if not, it is rejected. [19]

The payback period is widely used by large firms to evaluate small projects and

by small firms to evaluate most projects. Its popularity results from its

computational simplicity and intuitive appeal. It is also appealing that it

considers cash flows rather than accounting profits. By measuring how quickly

the firm recovers its initial investments, the payback period also gives implicit

consideration to the timing of cash flows and therefore to the time value of

money. Because it can be viewed as a measure of risk exposure, many firms use

the playback period as a decision criterion or as a supplement to other decision

techniques. The longer the firm must wait to recover its invested funds, the

greater the possibility of a calamity. Therefore, the shorter the payback period,

the lower the firm’s exposure to such risk. [20]

The major weakness of the pay back period is that the appropriate payback

period is merely a subjectively determined number. It cannot be specified in light

of the wealth maximization goal because it is not based on discounting cash flows

to determine whether they add to the firm’s value.

A second weakness is that this approach fails to take fully into account the time

factor in the value of money.

A third weakness of payback period is its failure to recognize cash flows that

occur after the payback period. [21]

This technique gives a simple and clear cut idea about the recovery of firm’s

investment in a project.

Net Present Value (NPV)

Net present value (NPV) is a standard method for the financial appraisal of long-

term projects. Used for capital budgeting, and widely throughout economics, it

measures the excess or shortfall of cash flows, in present value (PV) terms, once

financing charges are met. It is also called net present worth (NPW). [22]

Formula

Each cash inflow/outflow is discounted back to its present value (PV). Then they

are summed. Therefore

Where

t - The time of the cash flow

N - The total time of the project

r - The discount rate (the rate of return that could be earned on an investment in

the financial markets with similar risk.)

Ct - the net cash flow (the amount of cash) at time t (for educational purposes,

C0 is commonly placed to the left of the sum to emphasize its role as the initial

investment). [23]

The present value of an investment project’s net cash flow minus the project’s

initial cash outflow. [24]

The net present value method is a discounted cash flow approach to capital

budgeting. [25]

In formula we have

Where, “k” is the required rate of return. [26]

Because, net present value (NPV) gives explicit consideration to the time value of

money, it is considered a sophisticated capital budgeting technique. All such

techniques in one way or another discount the firm’s cash flows at a specified

rate. This rate – often called discount rate, required rate, cost of capital, or

opportunity cost – is the minimum return that must be earned on a project to

leave the firm’s market value unchanged.

The net present value is found by subtracting a project’s initial investment (CF 0)

from the present value of its cash inflows (CFt) discounted at a rate equal to the

firm’s cost of capital (k).

When NPV is used, both inflows and outflows are measured in terms of present

dollars Because we are dealing only with investments that have conventional

cash flows patterns, the initial investment is automatically stated in terms of

today’s dollars. If it were not, the present value of a project would be found by

subtracting the present value of outflows from the present value of inflows. [27]

ACCEPTANCE CRITERION

accepted; if not, it is rejected. Another way to express the acceptance criterion is

to say that the project will be accepted if the present value of cash inflows

exceeds the present value of cash outflows. [28]

In this technique we determine the net value of cash inflows and cash outflows, if

the value is zero or more than zero projects can be accepted but if less than zero,

projects are rejected.

The internal rate of return (IRR) for an investment proposal is the discount rate

that equates the present value of the expected net cash flow (CFs) with the initial

cash outflow (ICO). If the initial cash outflow or cost occurs at time 0, it is

represented by that rate IRR, such that

Thus, IRR is the interested rate that discounts the stream of future net cash flow

– CFt through CFn – to equal in present value the initial cash outflow (ICO) at

time 0. [29]

The internal rate of return (IRR) is probably the most widely used sophisticated

capital budgeting technique. However, it is considerably more difficult than NPV

to calculate at hand. The internal rate of return (IRR) is the discount rate that

equates the NPV of an investment opportunity with $0 (because the present value

of cash inflows equals the initial investment). It is the compound annual rate of

return that the firm will earn if it invests in the project and receives the given

cash inflows.

Mathematically, the IRR is the value of k that causes NPV to equal $0.

[30]

The internal rate of return (IRR) is a capital budgeting metric used by firms to

decide whether they should make investments. It is an indicator of the efficiency

of an investment, as opposed to net present value (NPV), which indicates value or

magnitude.

The IRR is the annualized effective compounded return rate which can be

earned on the invested capital, i.e., the yield on the investment.

A project is a good investment proposition if its IRR is greater than the rate of

return that could be earned by alternate investments (investing in other projects,

buying bonds, even putting the money in a bank account). Thus, the IRR should

be compared to any alternate costs of capital including an appropriate risk

premium. [31]

ACCEPTANCE CRITERION

The acceptance criterion generally employed with the internal rate of return

method is to compare the internal rate of return to a required rate of return,

known as the cutoff of hurdle rate. We assume for now that the required rate of

return is given. If the internal return of rate exceeds the required rate, the

projects accepted; if not, the project is rejected. [32]

Profitability Index

The ratio of the present value of a project’s future net cash value to the project’s

initial cash outflow.

The profitability index (PI), or benefit-cost ratio, of a project is the ratio of the

present value of future net cash flows to the initial cash out flow.

It can be expressed as:

[33]

proposed project. The ratio is calculated as follows:

and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking

projects because it allows you to clearly identify the amount of value created per

unit of investment, thus if you are capital constrained you wish to invest in those

projects which create value most efficiently first. [34]

ACCEPTANCE CRITERION

acceptable. For any given project, the net present value and the profitability

index methods give the same accept-reject signals. [35]

gained with the cost of a project.

In finance the equivalent annual cost (EAC) is the cost per year of owning and

operating an asset over its entire lifespan.

comparing investment projects of unequal life spans.

annuity factor. Equivalently, the NPV of the project may be multiplied by the

loan repayment factor.

EAC=

[36]

This technique is used when the two projects of unequal lifespan are under

consideration. They are compared by this technique by looking into the year by

year expenses of the two projects. Project with greater EAC will be rejected.

References

1. James Van Horne and John Wachowicz “Fundamentals of Financial

Management” (FFM) Pg 316

2. Lawrence Gitman “Principles of Managerial Finance” (PMF) Pg 356

3. www.en.wkipedia.org/wiki/Capital_budgeting

4. www.netmba.com/finance/capital/budgeting

5. FFM Pg 320

6. PMF Pg 356

7. PMF Pg 356

8. FFM Pg 316-317

9. PMF Pg 356

10. FFM Pg 317

11. PMF Pg 357

12. FFM Pg 316

13. PMF Pg 357

14. PMF Pg 357

15. FFM Pg 334

16. www.en.wikipedia.org/wiki/Capital_budgeting

17. FFM Pg 334

18. FFM Pg 334

19. FFM Pg 334-335

20. PMF Pg 398

21. PMF Pg 399

22. www.en.wikipedia.org/wiki/Net_present_value Lin, Grier C.I ; Nagalingam,

San V. (2000) CIM Justification London: Taylor Francis 36

23. www.en.wikipedia.org/wiki/Net_present_value#formula

24. FFM Pg 337

25. FFM Pg 337

26. FFM Pg 338

27. PMF Pg 401

28. FFM Pg 338

29. FFM Pg 335-336

30. PMF Pg 403

31. www.en.wikipedia.org/wiki/Internal_rate_return

32. FFM Pg 337

33. FFM Pg 340

34. www.en.wikipedia.org/wiki/Profitability_index

35. FFM Pg 340

36. www.en.wikipedia.org/wiki/Equivalent_Annual_Cost

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