a: What is capital budgeting?

Are there any similarities between a firms capital budgeting decision and an individuals investment decisions? Capital Budgeting A capital expenditure is an outlay of cash for a project that is expected to pro duce a cash inflow over a period of time exceeding one year. Examples of project s include investments in property, plant, and equipment, research and developmen t projects, large advertising campaigns, or any other project that requires a ca pital expenditure and generates a future cash flow. Because capital expenditures can be very large and have a significant impact on the financial performance of the firm, great importance is placed on project sel ection. This process is called capital budgeting. The process of planning for purchases of long-term assets. Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures, therefore irreversible once mad e. Very important to firms future. For example: Suppose our firm must decide whether to purchase a new plastic mold ing machine for $125,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? Similarities between capital budgeting decision and individual investment decisi on Capital budgeting is very necessary for a proper management. The manager is the one to select the best form and type of investment. And to do this a sound proce dure well planning and evaluation is needed. This process is known as capital bu dgeting. Or in some simple words capital budgeting is the process of recording a dditions to the assets. Capital budgeting process is very much same as those of individual investment de cisions as they both involve these same steps: They calculate the risk involved in the cash flows. They also in favor find the rate of return Estimation of the cash flow that is, the rate of interests and dividends as invo lved in the case of shares, debentures or bonds and proper optimization of cash flow is common in both of the sides. They both consider if the Present value of the inflows is greater than the prese nt value of the outflows which means that net present value should be positive. Calculated rate of return is also to be considered that if it is higher than the total project cost of the capital. Determination of appropriate discount rate which is based on the level of the ri sk in the project and the interest rate is also common in both case. Several Capital budgeting techniques are also very much similar to those of the individual investment decisions as shown in the above points. Capital budgeting decisions and individual investment decisions are same in many ways and their wa y of interpretation is somewhat identical as shown above. Capital budgeting is related with the investments decisions which have to be mad e in long-term fixed assets and working capital management. Capital structure is related with the financing decisions regarding the debt and equity combinations, in which proportion debt and equity has to be maintained. b: What is the difference between independent and mutually exclusive projects? B

etween projects with normal and non-normal cash flows? Independent projects if the cash flows of one project are unaffected by the acce ptance of the other projects. Mutually exclusive projects if the cash flows of one project can be adversely im pacted by the acceptance of the other project. These are a set of projects that perform essentially the same task, so that acceptance of one will necessarily me an rejection of the others. Mutually exclusive is the situation in which only one of two projects designed f or the same purpose can be accepted and independent projects is a project whose feasibility can be assessed without consideration of any others. o Normal cash flow stream Cost (negative CF) followed by a series of posit ive cash inflows. One change of signs (- + + + + +) CF Year 5 ($) (500) 0 150 1 150 150 2 150 150 3 4

o Non normal cash flow stream Two or more changes of signs. Most common: C ost (negative CF), then string of positive CFs, then cost to close project. Nucl ear power plant, strip mine, etc. .(- + + - + +). Examples: Nuclear power plant, strip mine, etc. CF Year 5 c :(1) What is the payback period? Find the paybacks for Projects L and S? Payback Period The payback period is defined as the expected number of years required to recove r the investment, and it was the first formal method used to evaluate capital bu dgeting projects. First, we identify the year in which the cumulative cash infl ows exceed the initial cash outflows. That is the payback year. Then we take t he previous year and add to it un-recovered balance at the end of that year divi ded by the following year s cash flow. Generally speaking, the shorter the payb ack period, the better the investment. ($)(500) 0 200 1 100 2 (200) 3 400 4 300

(2) What is the rationale for the payback method? According to the payback criterion, which project or projects should be accepted if the firms maximum acceptable payback is 2 years, and if Project L and S are i ndependent? If they are mutually exclusive?

Rationale for the payback method Firm cut-offs are subjective. Does not consider time value of money. Does not consider any required rate of return. Ignores cash flows occurring after the payback period. Does not consider all of the projects cash flows. (3)What is the difference between regular and discounted payback period? Regular Payback Period The payback period is defined as the expected number of years required to recove r the investment, and it was the first formal method used to evaluate capital bu dgeting projects. The regular payback method ignores cash flows beyond the payback period, and it does not consider the time value of money. The payback provides an indication of a projects risk and liquidity, because it shows how long the invested capital wi ll be at risk. Simple payback method does not care about the time-value of money principle whil e discounted payback period do take care of this principle in calculation. Discounted Payback Uses discounted cash flows rather than raw cash flows. Discounts the cash flows at the firms required rate of return. Payback period is calculated using these discounted net cash flows.

The Discounted Payback method is similar to the regular payback method except th at it discounts cash flows at the projects cost of capital. It considers the tim e value of money, but it ignores cash flows beyond the payback period.

(4) What is the main disadvantage of discounted payback? Is the payback method o f any real usefulness in capital budgeting decisions? There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you d receiv e from an investment and to adjust for the time value of money. Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the va lue of a company. Instead of trying to project the cash flows to infinity, termi nal value techniques are often used. A simple annuity is used to estimate the te rminal value past 10 years, for example. This is done because it is harder to co me to a realistic estimate of the cash flows as time goes on. The main disadvantage of discounted payback is in below: Ignores the time value of money. Ignores CFs occurring after the payback period. Tend to bias in favor of short term projects.