...purchasing a new plant, constructing a new building, or engaging in a new venture is profitable enough to pursue. (Investopedia. 2015) When making crucial investment decisions, capital budgeting gives businesses a more informed way of deciding. This is because investment decisions are weighed in terms of the cash flows over the duration of the new venture or investment. This way, a company can have more visibility in terms of monitoring its cash flows for every period. Consequently, businesses can make an initial evaluation of pushing through a certain project or not. This is what makes capital budgeting very useful since companies...
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...Capital Budgeting Techniques | | GLOSSARY Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets. Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected. Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs. As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefit analysis. We are asking a very simple question: "If I purchase this fixed asset, will the benefits to the company be greater than the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale (similar to the one above) to see which is greater. A complicating factor is that the inflows and outflows may not be comparable: cash outflows (costs) are typically concentrated at the time of the purchase, while cash inflows (benefits) may be spread over many years. The time value of money principle states that dollars today are not the same as dollars in the future (because we would all prefer possessing dollars today to receiving the same amount of dollars in the future). Therefore, before we can place...
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...CHAPTER 7—PROJECT CASH FLOWS AND RISK TRUE/FALSE 1. If an investment project makes use of land that the firm currently owns, the project should be charged with the opportunity cost of the land. 2. Net incremental operating cash flow is calculated by adding back the change in depreciation to the change in income after taxes. 3. A key difference between replacement and expansion project analyses is that with replacement, the incremental cash flows are measured as the net difference between projected cash flows from the current productive assets and cash flows of the proposed new productive assets. 4. Empirical studies of risk strongly support the contention that investors who are well diversified focus exclusively on market risk when they establish required returns. 5. Quantification of risk is the easiest part of incorporating risk into capital budgeting; treatment of that calculated risk measure is more difficult. 6. If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment. 7. Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates. 8. A sunk cost is a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. These sunk costs are...
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...Budgeting? Nancy Garcia and Digital Solutions Digital Solutions, a software development house, is considering a number of new projects, including a joint venture with another company. Digital Solutions would provide the software expertise to do the development, while the other company, American Financial Consultants (AFC) would be responsible for the marketing. Nancy Garcia of Digital Solutions would be responsible for assessing the financial viability of the plan. Information about the costs and revenues of the project would come from the accounting, production and marketing groups of the two companies; however, Ms. Garcia would have to put the information together, and provide a preliminary analysis that she would present to the company’s managers. Capital budgeting is the process of making a decision about the financial desirability of a project. The proposed software development project at Digital Solutions is an example of this kind of problem. We will see how Nancy Garcia approaches this problem as a way to learn the techniques of capital budgeting. The Big Picture Businesses are about increasing the wealth of their owners, which means that they should pursue all the profitable projects that they can. Capital budgeting is about deciding which projects are profitable and add to the value of the firm. Sometimes the firm has to choose between two or more projects and can only pick one. For example, you may have a choice between two air-conditioning systems with different installation...
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...even though depreciation is not a cash expense. b. Corporations should fully account for sunk costs when making investment decisions. c. Corporations should fully account for opportunity costs when making investment decisions. d. Statements a and c are correct. e. All of the statements above are correct. Relevant cash flows Answer: c Diff: E . A company is considering a new project. The company’s CFO plans to calculate the project’s NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the company’s cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows? a. Any sunk costs associated with the project. b. Any interest expenses associated with the project. c. Any opportunity costs associated with the project. d. Statements b and c are correct. e. All of the statements above are correct. Relevant cash flows Answer: d Diff: E . When evaluating potential projects, which of the following factors should be incorporated as part of a project’s estimated cash flows? a. Any sunk costs that were incurred in the past prior to considering the proposed project. b. Any opportunity costs that are incurred if the project is undertaken. c. Any externalities (both positive and negative) that are incurred if the project is undertaken. d. Statements b and c are correct. e. All of the statements above are correct. Relevant...
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...------------------------------------------------- Capital Budgeting: Estimating Cash Flow ------------------------------------------------- and Analyzing Risk ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 13-1 The firm’s FCFs reflect both its past and current investments. Past investments produce current FCFs, but current investments are expected to add to FCF at some future point. Conceptually, a project’s projected cash flows and are expected to contribute that same amount to the firm’s future free cash flows. In practice, project cash flows are analyzed to determine what projects the firm will invest in, and then the sum of those investments, and the cash flows they produce, will in the future be reflected in the firm’s FCFs. If a firm identifies and then invests in positive NPV projects, this will increase the value of its operations as determined by the FCF model. The central issue is analyzing individual projects, and here the key factor is assessing the cash flows. See the BOC spreadsheet model. We go through the model to show how capital budgeting projects are analyzed. In this case, the initial NPV, IRR, and MIRR, all evaluated at the 12% average cost of capital and using the expected input values, indicate that the firm should accept the project. However, the risk analysis as done in the scenario analysis indicates that the project is riskier than average, hence the evaluation should be done with a somewhat higher WACC. Note that firms have two types of assets—-assets-in-place...
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...the responsibility of management to ensure that they choose the right mix of debt and or equity so that there is a balance between the risks and reward. In finding the perfect capital structure in terms of risk/rewards management has to take into consideration interest payment, the company’s cash flows, dividends payment, the expected return on investment and so on. ("Capital structure decision," 2010) Competition Bikes Inc. has several alternatives for its capital structure mix in financing the Canadian expansion. Below is the data for the capital structure mix. Based on the capital structure analysis we see that Competition Bikes Inc has five different alternatives namely: 1. A capital structure consisting of only 9% bonds. 2. A capital structure consisting of only stocks, 50% preferred and 50% common stock. 3. There is a mix of 20% bond and 80% common stock 4. There is also a mix of 40% bond and 60% common stock. 5. The final mix is 60% bond and 40% common stock. The earnings per share (EPS) is the portion of the company’s profit that is allocated to each share of common stock as defined by the investopedia dictionary. This figure is very important to shareholders as it is used in determining the price per share. In our analysis we will be using the EPS to help us determine the best capital structure as well as the risk and rewards...
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...has experienced slower growth and increased competition for market share. Three months earlier Primus was competing with two foreign firms to sell the equipment to Avantjet. Primus is looking for a lease with terms that will give them a NPV that is higher than the asset they are lending. Primus will assume credit risks and must decide if the return from the lease is favorable enough for the risk taken. Primus will also be dealing with a residual value risk. If primus does not lease the system, they will probably lose the customer. Primus’s objective is to asses the risk and determine if the lease is economically attractive. The problem with creating these lease terms is that Avantjet’s cost of debt and tax rate are unknown to Primus. Because of this we created four different leasing option scenarios. Each scenario offered a high and low cost of debt with either zero or 34% tax. In our analysis we calculated Avantjet's cost of debt to be about 13%. As Avantjets cost of debt rises lease financing becomes more attractive. The lower the tax rate also makes leasing attractive option. The discount used for these lease payments is the after tax cost of debt. This is because lease payments are very predictable and behave much like loan payments. When evaluating the competition from Faulhaber and Honshu we compared the IRR of the lease costs between the companies lease options. From this we found that Primus’s options are superior to Honshu’s lease proposal under all four...
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... What is Financial Management Financial management can be defined as the management of the finances of an organisation in order to achieve the financial objectives of the organization. The usual assumption in financial management for the private sector is that the objectives for the company is to maximize shareholders wealth. 1.2. Financial Planning The financial manager will need to plan to ensure that enough funding is available at the right time to meet the needs of the organisation for short, medium and long-term capital. a) b) 1.3. In the short-term, funds may be needed to pay for purchases of inventory, or to smooth out changes in receivables, payables and cash: the financial manager is here ensuring that working capital requirements are met. In the medium or long term, the organisation may have planned purchase of fixed assets such as plant and equipment, for which the financial manager must ensure that funding is available. Financial Management decisions The financial management decisions relate to investment, financing and dividends. The management of risk must also be considered. Investments in assets must be financed somehow. Financial management is also concerned with the management of short-term funds and with how funds can be raised over the long term. The retention of profits is a financing decision. The other side of this decision is that if profits are retained, there is less to pay to shareholders as dividends, which might deter investors. An appropriate...
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...of return a company must pay to its long-term creditors and shareholders for the use of their funds. When WACC is used as the discount rate, it serves as a screening device in net present value analysis. To calculate WACC we must first find the expected return on share i E(Ri), using the securities market line equation, as follows: E(Ri) = RF + βi (E(RM) - RF) = 3% + 1.2 (13% - 3%) = 15% E(Ri) = expected return on share i E(RM) = expected return on the market = (Market risk premium + the risk free rate of return) = 13% RF = risk-free rate of return = 3% βi = beta of share i =1.2 As such, WACC can be calculated using the following equation: WACC = [D/(D+E)*RD](1-T) + [E/(D+E)*RE] = [40%*6%(1-28%)] + [60%*15%] = 10.728% D = value of total debt E = value of shareholders’ equity RD = cost of debt RE = cost of equity T = corporate tax rate b) NPV, IRR, & Payback Period Assumptions: - Generally speaking, because of difficulties related to identifying costs with particular activities and determining the future benefits, all R&D costs are expensed when incurred. They do not become part of the capitalised investment asset. As such, the €20m OMG has spent on R&D will be excluded from the NPV calculations, since this cost will be incurred regardless of the decision to proceed with the project. - The scenario also implies that regulatory approval is well underway and is expected shortly. This...
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...is to maximize the shareholders’ value. The shareholders’ wealth is measured by the returns they receive on their investment. Returns are in two parts, first in the form of dividends and the second in the form of capital appreciation reflected in market value shares, of which market value is the dominant part. The share prices are influenced by the extent to which the management is able to meet the expectation of the shareholders. Various measures like the return on capital employed , return on equity, earnings per share, net profit margin, operating profit margin have been used to evaluate the performance of the business. The shareholders require at least a minimum rate of return on their investment depending on the risk in the investment. Sometimes, the industry average or the competitor’s performance may be considered as a benchmark, which may not be...
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...an MNC when it establishes its capital structure. l l An MNC finances its operations by using a mixture of fixed interest borrowing and equity financing that can minimize the overall cost of capital (the weighted average of its interest rate and dividend payments). By minimizing the cost of capital used to finance a given size and risk of operations, financial managers can maximize the value of the company and therefore maximize shareholder wealth. 25 26 MULTINATIONAL COST OF CAPITAL AND CAPITAL STRUCTURE BACKGROUND ON COST OF CAPITAL Apart from working capital, a firm’s capital consists of equity (retained earnings and funds obtained by issuing shares) and debt (borrowed funds). With these funds a firm invests in a portfolio of projects, each project potentially offering different risks and different returns. The interest rate that the firm applies or charges to these projects (the cost of using the firm’s capital) will therefore vary according to the project’s particular risk. Profitable investment in this context is where the firm invests in projects that achieve returns greater than that required by their risk. A project that achieves a 20% return from investing in car parks (safe) is arguably a better performer than a project achieving a 25% return from financing a musical show (risky) in that many of the musical shows will fail and most of the investments in car parks will succeed – it is only a higher expected return. For convenience, rather than use NPV terminology...
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...An analysis was conducted on the financial statements of Custom Snowboards, Inc. for consideration of a 5-year-loan with our institution. Financial statement line items, risk assessments, and ratios were all examined with pertinent items that need to be considered are included in this report, and if granted the loan, can track the progress of the company’s ability to repay the loan. The financial statement line items of Custom Snowboards, Inc. were analyzed focusing on areas that were influential in determining the risk factors of extending a 5-year-loan to the company by assessing these bottom line issues: (1) the company’s ability to make money, profitability; (2) the company’s ability to pay it’s bills, liquidity (http://www.ehow.com/how_2317586_improve-liquidity.html), and in the meet long-term financial obligations and business longevity, solvency (http://www.ehow.com/info_8752952_solvency-accounting.html). Banks pay close attention to borrowing liabilities before granting a loan to evaluate the how much the company owes and who the existing creditors are. Liability trends are gauged to ensure the bank is not over-extending itself to its customers. Assets are a prime factor in a bank’s lending decision as it represents the resources the borrower has to generate cash to repay a loan. Short-term solvency is determined by the company’s existing assets. Bankers pay special attention to profits and losses to assess the company’s revenues in search of trends that can limit the...
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...1.0 Introduction 1.1 Company Profile Company Name : Northern Health Clinic (NHC) Owners : Dr. EdryYussof and Dr. Wilson Chen City : Jitra, Kedah, Malaysia Postal Code : 06010 Phone Number : (+604)2028606 Year Established : 5 years ago Business Activities : provide traditional medical care and preventive medicine Objective : to ensure that patients are in healthy and fit condition Employee : 17 Patient base : 3500 1.2 Company Background Dr. Wilson Chen and Dr. EdryYussof are the founders of Northern Health Clinic which they combined their individual practices five year ago and form the Clinic. The clinic located at the busiest section of the Jitra town in the new shopping mall. NHC’s activities focus on preventive medicine to help patient maintain health and fitness by providing traditional medical care. There are 17 staffs in Northern Health Clinic include 3 nurses, 4 physical therapists, 4 doctors and 6 office staff workers. Currently, NCH has a patient base of 3500 person, most of them provide insurance coverage for employee wellness and health maintenance. 1.3 Current system of the company The current system that used by the Northern Health Clinic is manual system. Each of the six office staff people has their responsibility in particular work area. One of the employee is handles office payroll, tax reporting and profit distribution among the associates. Another one handles most of paperwork...
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...H A P T E R 3 Project Selection and Portfolio Management Chapter Outline 70 Project Management: Achieving Competitive Advantage, Second Edition, by Jeffrey K. Pinto. Published by Prentice Hall. Copyright © 2010 by Pearson Education, Inc. 000200010270649984 PROJECT PROFILE Project Selection Procedures: A Cross-Industry Sampler INTRODUCTION 3.1 PROJECT SELECTION 3.2 APPROACHES TO PROJECT SCREENING AND SELECTION Method One: Checklist Model Method Two: Simplified Scoring Models Limitations of Scoring Models Method Three: The Analytical Hierarchy Process Method Four: Profile Models 3.3 FINANCIAL MODELS Payback Period Net Present Value Discounted Payback Internal Rate of Return Options Models Choosing a Project Selection Approach PROJECT PROFILE Project Selection and Screening at GE: The Tollgate Process 3.4 PROJECT PORTFOLIO MANAGEMENT Objectives and Initiatives Developing a Proactive Portfolio Keys to Successful Project Portfolio Management Problems in Implementing Portfolio Management Summary Key Terms Solved Problems Discussion Questions Problems Case Study 3.1 Keflavik Paper Company Project Profile Case Study 3.2 Project Selection at Nova Western, Inc. Internet Exercises Notes Chapter Objectives After completing this chapter you should be able to: 1. Explain six criteria for a useful project-selection/screening model. 2. Understand how to employ checklists and simple scoring models to select projects. 3. Use more sophisticated...
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