For Ibf Capt. Budgeting

8/13/2019 For Ibf Capt. Budgeting

1/27

CAPITALBUDGETTING


2/27

CHAPTER OVERVIEW:Defined Capital Budgeting

Objectives of Capital Budgeting

The Capital Budgeting SystemEvaluation of Proposed Capital Expenditures

Methods of Economic Evaluation

Risk, Uncertainty and Sensitivity


3/27

Financial Management is largely concerned with Financing, Dividendand Investment decision of the firm with some overall goal in mind.

Corporate Finance Theory has developed around a of maximizing goalthe market value of the firm to its shareholders. This is also known asShareholder 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 itsowners.


4/27


5/27

Financing Decision deal with the firms optimal capitalstructure in terms of debts and equity.

Dividend Decisions relate to the form in which returnsgenerated by the firm are passed on to equity-holders.

Investment Decision deal with the way funds raised infinancial markets are employed in productive activities toachieve the firms overall goal; in other words, how muchshould be invested and what assets should be invested in.


6/27

What is Capital Budgeting? Capital Budgeting is primarily concerned with

sizable investments in long terms assets.

Capital budgeting(or investment appraisal) is theplanning process used to determine whether anorganization's long term investments such as newmachinery, replacement machinery, new plants, new

products, and research development projects areworth pursuing. It is budget for major capital, orinvestment, expenditures


7/27

Cont

Analysis of potential projects.

Long-term decisions; involve large expenditures.

Very important to organizations future


8/27

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


9/27


10/27

Steps in Capital BudgetingEstimate cash flows (inflows & outflows)

Assess risk of cash flows.

Determine r = WACC for project

WACC(Weighted Average Cost of Capital) is therate 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


11/27

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 onewould be adversely affected by the acceptance ofthe other.


12/27

The Capital Budgeting SystemCapital Budgeting System is a multi faceted activity.

There are several sequential stages in the process. Fortypical investment proposals of a large corporation,the distinctive stages in the capital budgeting processare depicted.


13/27


14/27

Strategic Planning- is the grand design of the firm andclearly identifies the business the firm is in and where

it intends to position itself in the future. It translatesthe firms corporate goal into specific policies anddirections, set priorities, specifies the structural,strategic and tactical areas of business development,

and guides the planning process in the pursuit of solidobjectives.


15/27

Qualitative Factors in Project

Evaluation


16/27

What is the payback period? The number of years required to recover a projectscost,

orHow long does it take to get the entitys money back?

The paybackmeasures the length of time it takes a companyto recover in cash its initial investment. This concept canalso be explained as the length of time it takes the projectto generate cash equal to the investment and pay thecompany back. It is calculated by dividing the capitalinvestment by the net annual cash flow. If the net annualcash flow is not expected to be the same, the average of thenet annual cash flows may be used.


17/27


18/27

E.g. ABC Company , the cash payback period is threeyears. It was calculated by dividing the $150,000 capital

investment by the $50,000 net annual cash flow($250,000 inflows - $200,000 outflows)


19/27

The shorter the payback period, the sooner the companyrecovers its cash investment. Whether a cash payback

period is good or poor depends on the company'scriteria for evaluating projects. Some companies havespecific guidelines for number of years, such as twoyears, while others simply require the payback period

to be less than the asset's useful life.


20/27

Strengths of Payback:1. Provides an indication of a projects risk andliquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the Time Value of Money.

2. Ignores CFs occurring after the payback period.


21/27

Annual rate of return method Theannual rate of returnuses accrual-based net income to

calculate a project's expected profitability. The annual rate ofreturn is compared to the company's required rate of return. Ifthe annual rate of return is greater than the required rate ofreturn, the project may be accepted. The higher the rate ofreturn, the higher the project would be ranked.

The annual rate of return is a percentage calculated by dividingthe expected annual net income by the average investment.

Average investment is usually calculated by adding thebeginning and ending project book values and dividing by two.

S l P bl


22/27

Sample Problem

Assume the Cottage Gang has expected annual net

income of $5,572 with an investment of $150,000 and asalvage value of $5,000. This proposed project has a7.2% annual rate of return ($5,572 net income $77,500 average investment).


23/27


24/27

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 ofaccounting and not actual cash f lows or time value ofmoney.


25/27

Discounted Cash Flow Methods The Net Present Value Method

Internal Rate of Return Method

Note : Considering the time value of money is important whenevaluating projects with different costs, different cash flows, anddifferent service lives. Discounted cash flow techniques, such asthe net present value method, consider the timing and amountof cash f lows. To use the net present value method, you will need

to know the cash inflows, the cash outflows, and the company'srequired rate of return on its investments. The required rate ofreturn becomes the discount rate used in the net present valuecalculation. For the following examples, it is assumed that cashflows are received at the end of the period.


26/27

The Net Present Value Method

This valuation requires estimating the size and timing of allthe incremental cash flows from the project. These futurecash flows are then discounted to determine their present

value. These present values are then summed, to get theNPV. See also Time value of money. The NPV decision ruleis to accept all positive NPV projects in an unconstrainedenvironment, or if projects are mutually exclusive, acceptthe one with the highest NPV.

The NPV is greatly affected by the discount rate, so selecting

the proper rate - sometimes called the hurdle rate - iscritical to making the right decision. The hurdle rate is theminimum acceptable return on an investment.


27/27

Internal rate of returnThe internal rate of return (IRR) is defined as the discountrate that gives a net present value (NPV) of zero. It is acommonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPVmethod for (non-mutually exclusive) projects in anunconstrained environment, in the usual cases where anegative 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 mutuallyexclusive projects, the decision rule of taking the projectwith the highest IRR - which is often used - may select aproject with a lower NPV

For Ibf Capt. Budgeting

Documents

Transcript of For Ibf Capt. Budgeting