...CAPITAL BUDGETING: ADVANTAGES AND LIMITATIONS. SEPTEMBER 2012 CHAPTER ONE INTRODUCTION 1.0 Background Study Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability. In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process. Capital budgeting is a process...
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...Global Business Strategies Week 4 Discussion Questions MGT/448 May 02, 2013 Global Business Strategies Week 4 Discussion Questions What are the elements of capital budgeting? How do you determine these elements in the Global business arena? Provide examples of how you would use capital budgeting analysis to determine the desirability of global projects. There are three different types of capital budgeting processes: centralized, decentralized and integrated. In centralized capital budgeting, top management make all important strategic capital budgeting decisions. Operating managers bid on implementing projects selected by top management. In decentralized capital budgeting operating managers identify and initiate projects that are approved by top management based upon projected financial performance. Integrated capital budgeting has elements of both decentralized and centralized capital budgeting. Capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value, and viability. In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. The two things to consider when you would use capital budgeting in global projects are the following; What will the Project Cost? This is the first and most basic question a company must answer before pursuing a project. Identifying the cost...
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...Name: Professor’s name: Dr. Wright Course: AF 211 Accounting for Planning and Control Managers in making investment decisions are faced with the problem of limited resources. This, therefore, necessitates an understanding of the topic of capital budgeting. Capital budgeting is the process of determining and pursuing investments which cash flows are expected in the future period usually more than a year. It entails the decision on the acquisition of new assets or equipment that is to be utilized by the business to increase its future cash flows and profitability. Managers are, therefore, faced with the challenge of determining which project to invest in order to avert the adverse effect on the financial performance. In making investment decisions, various factors must be considered. Managers have to know that the success of the business entirely depends on how best the investments are analyzed before they are undertaken. First, capital budgeting requires large capital outlay (Dugdale 16). Most of the capital budgeting decisions require a large proportion of business funds. It, thus, implies that failure to make proper investment decisions will lead to losses for the organization. Secondly, investment decisions are irreversible. After deciding on what projects to invest in, managers will lack the ability to reverse their decisions, i.e., equipment once acquired cannot be easily disposed of. The managers must therefore be careful before settling on a particular investment...
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...Part A “Capital budgeting over the years has become a sophisticated process for the finance officer. The different methods available to the finance officer have increased and become more accurate and centred upon the goal of maximizing wealth. However has there been an increase in the usage of these new methods or are decision makers still using the easier methods?” Capital budgeting is a tool management use to make investment decisions. Despite the pitfalls pointed out in Yee-Ching Lilian Chan’s article “Use of capital budgeting techniques and an analytic approach to capital investment decisions in Canadian Municipal Governments”, which includes overemphasis on the quantifiable aspects of capital projects, random cut offs on the timing and the amount of cash flows, Unrealistic discount rates or IRR assumptions. Methods such as profitability index, internal rate of return, breakeven, payback period and net present value are all discounted cash flows which are commonly used in practice. In 2001 Elijelly, A & Abuldris published an article “ A survey of capital budgeting techniques in the public and private sectors of a less developed country, Sudan” They concluded that most public enterprises in less developed countries, do not apply any capital budgeting methods when making investment decisions. The payback method was the most widely used followed by the Internal rate of return in the private and public sectors that did use capital budgeting techniques. “In contrast to the...
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...CHAPTER ONE Introduction Understanding and being able to use capital budgeting techniques and investment appraisal tools is usually a standard requirement for most business degrees. In addition learning such methods will also give one an advantage in a real business situation, in which there is the consideration of significant capital expenditure project. Capital budgeting assists management decisions making on the process of ensuring growth of the organization. The techniques are divided into two types: one, Traditional (non-discounting) that includes pay back method, accounting rate of return (ARR). Two, discounting cash flow that includes net present value (NPV), internal rate of return (IRR) Profitability Index (PI). Before an investment appraisal is conducted, there are a number of points to keep in mind. Whilst the tool presented will give an evaluation of the worth of a project, one should consider that the answer is only a guide. In short, the results of an investment appraisal should be considered in conjunction with both common sense and other qualitative factors such as a business’s overall strategy. Secondly, before an investment appraisal is conducted, one should consider whether or not the project is mutually exclusive. Where a project is mutually exclusive, then only the best project should be selected. Where on the other hand, projects are independent; one may select all projects which give the appropriate return. 1.1 Background of the study Corporate finance...
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...Phase 3 Individual Project/DB Capital Budgeting Janella Chapman ACCT-614/Applied Managerial Accounting March 15, 2013 Professor Tracie Edmond I. Overview As companies look to grow and expand operations, product lines, or locations, capital budgeting is the method used by management in evaluating if projects and long-term investments will be profitable for the company. Capital budgeting analysis evaluates projects that will have cash flows for longer than a year. Capital budgeting helps management analysis if investments will be profitable and valuable to the company compared to the initial investment needed and the risk associated with the investment. There are many capital budgeting methods management may use to ensure the project or investment is aligned with the corporate strategy of a company. In the capital budgeting process, management evaluates different capital budgeting techniques to ensure the company has the resources to invest in the project, and also helps management determine if the investment will help achieve the goals and objectives of the company. The goal of capital budgeting is to evaluate the costs of an investment to the initial capital to determine if the investment will generate more capital or cash flow for the company. The four capital budgeting techniques used by management are Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and Payback method. SAC has developed new manufacturing techniques to offer special...
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...Management J. Volume 2 No. 1 (January 1989) ,' CAPITAL BUDGETING PRACTICES OF INDIAN COMPANIES I. M. PANDEY ' Objective " The objectives of this study are: (a) to document the capital bud geting policies and practices of companies in India, a developing country, and contrast them with those of USA and UK, the developed countries, and (b) to ascertain how business executives look upon the linkage between corporate strategy and investment decision-making. Capital expenditure planning and control is a process of facilitating decisions covering expenditures on long-term assets. Since a company's survival and profitability hinges on capital expenditures, specially the major ones, the importance of the capital budgeting process cannot be over-emphasized. Sample and Methodology We have followed an intensive interview-cum-questionnaire method. Two questionnaires—one dealing with investment evaluation practice and second with other phases—were sent to companies which had agreed to participate in the study. In all, 14 companies were studied. The responding companies belonged to different businesses. In terms of size (sales and number of employees), capital intensity (net tangible fixed assets), volume of spending (capital expenditure incurred), and level of technology, they represent a variety (Table 1). The study relates to 1984. •-, Capital Expenditure: How Defined Strictly speaking, capital expenditure includes all those expenditures which are expected to produce...
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...SUMMARY OUTLINE CAPITAL BUDGETING PRACTICES OF INDIAN COMPANIES Introduction Corporate strategy provides the focal point for the firm's long-run strategic planning. The capital budgeting system, particularly for large strategic projects, is determined in the context of strategic planning and, thus, it is a top-down process. Corporate strategy and strategic planning play the most crucial role at the identification and evaluation phases. Operating and administrative capital budgeting decisions can be decided at lower /middle level of management within the overall strategic framework and guidelines from top management. The capital budgeting system at lower/middle level will largely be a bottom up process. It may be noted that external and internal environment provides a context to the company to establish and review its missions, concerns, and multiple objectives which, in turn, shape its corporate strategy. Objectives There are two objectives of this study: a) To document the capital budgeting policies and practices of companies in India, a developing" country, and contrast them with those of USA and UK, the developed countries b) To ascertain how business executives look upon the linkage between corporate strategy and investment decision-making. Sample and Methodology The study used interview-cum-questionnaire method and sent to 14 companies different businesses which had agreed to participate in all. Methods of Evaluation The study was...
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...Week Four Discussion Questions 1.What is the cost of capital? How do you calculate the cost of capital? Why is it important in capital budgeting decisions. (due by midnight on Thursday) Cost of capital is the required return or the opportunity cost for a project in order to increase the value of the firm in the market place. It helps managers evaluate if an investment is worthwhile by setting a benchmark for the minimum rate of return. Cost of capital may be used as the measuring road for adopting an investment proposal. It measures the financial performance and determines the acceptability of all investment opportunities. The weighted average cost of capital (WACC) is used to measure a firm’s cost of capital. 2. What are some capital budgeting tools? Explain Net Present Value (NPV) analysis. (Due by midnight on Thursday) Different tools used in capital budgeting include NPV, discounted-cash-flow analysis, IRR, and MIRR. NPV is used to evaluate capital budgeting projects by determining the difference between the market value of an item and what it costs. 3. What is the weighted average cost of capital (WACC)? How is it calculated? What are business investment rules? (Due by midnight on Saturday) WACC is the average costs of financing sources either debt or equity. The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing. WACC= E/V*Re+D/V*Rd*(1-Tc) Re=cost of equity, Rd=cost of debt, E=market value of the firm’s equity...
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...Capital Budgeting Introduction A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of capital budgeting relies on the work of people in the areas of industrial engineering, research and development, and management information systems (among others) for the creation of investment opportunities. As such, it is important to suggest that students keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Because a project is financially sound, it must be ethically sound, right? Well . . . the question of ethical appropriateness is less frequently discussed in the context of capital budgeting than that of financial appropriateness. Consider the following simple example: The American Association of Colleges and Universities estimates that 10 percent of all college students cheat at some time during their postsecondary education careers. You might pose the ethical question of whether it would be proper for a publishing company to offer a new book How to Cheat: A User's Guide. The company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year one and 5,000 volumes in each of the following two years. The immediate printing costs for the 20,000 volumes would be $20,000. The book would sell for $7.50 per copy and...
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...Capital Budgeting Case for week 6 Capital Budgeting Process: Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. In the capital budget case the team analyzed and put a 5 year income statement for corporation A and corporation B. The income statement started with the information provided by the case information for the assignment It is important for business owners to analyze projects and their costs before going through with them. In order to do this they must project the value of the project to see if it is going to bring them the profits they desire. For example, if a business owner is interested in acquiring a new company, he or she must look at different aspects of the company as it is now and project the value over several years to ensure that a profit will be made. In the case presented, two companies are being compared to see which would be the better company to acquire based on income statement and cash flow projections, Net present value (NPV), and Internal rate of return (IRR). This paper will go over the reasoning for the final decision based on the analysis of the projections as well as the importance and differences of NPV and IRR. Net Present Value (NPV) The NPV is the difference of the discounted cash inflows and the discounted cash outflows. The NPV...
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...4212 SEPTEMBER 15, 2010 TIMOTHY LUEHRMAN HEIDE ABELLI New Heritage Doll Company: Capital Budgeting In mid-September of 2010, Emily Harris, vice president of New Heritage Doll Company’s production division, was weighing project proposals for the company’s upcoming capital budgeting meetings in October. Two proposals stood out based on their potential to strengthen the division’s innovative product lines and drive future growth. However, due to constraints on financial and managerial resources, Harris knew it was possible that the firm’s capital budgeting committee would decline to approve both projects. She also knew that New Heritage’s licensing and retail divisions would promote compelling projects of their own. Consequently, Harris had to be prepared to recommend one of her projects over the other. The Doll Industry Revenues in the U.S. toy and game industry totaled $42 billion in 2008 and were projected to increase by 4.6% per year to $52.5 billion by 2013. The market was divided into two broad segments: video games (48%) and traditional toys and games (52%). The second segment was further divided into infant/preschool toys (14.5%), dolls (14.1%), outdoor & sports toys (12.3%), and other toys & games (59.1%) including arts and crafts, plush toys, action figures, vehicles, and youth electronics. The U.S. market for toys and games was dominated by large global enterprises that enjoyed economies of scale in design, production, and distribution. Revenues...
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...Capital Budgeting Processes and Techniques Keith A. Rossmiller Business 657 Instructor Maxwell September 3, 2012 Capital Budgeting 2 Capital Budget Processes and Techniques Investment decisions impact the long-term success or failure of a company. The capital budgeting theory assumes that the primary goal of a firm’s shareholders is to maximize firm value. The process of analyzing and prioritizing investment opportunities is capital budgeting. Capital budgeting involves three basic steps of identifying potential investments, analyzing the set of investment opportunities that will create shareholder value, and implementing and monitoring the investment projects that a firm should undertake. Managers need analytical tools to help them make the best investment decisions for their firm. This paper will explore six different methods of evaluating investment projects and their advantages and disadvantages. The six methods are the payback period, discounted payback period, net present value, profitability index, internal rate of return, and modified internal rate of return, which method is most used in business, and issues related to capital budgeting. Capital Budgeting 3 Payback Period The first...
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...averages cost of capital, discuss the use of multiple valuation techniques in reducing risks and calculate the net present value of future cash flows for each of the alternatives. Guillermo Navallez was owner of Guillermo Furniture Store located in Sonora Mexico. Guillermo Furniture Store has been manufacturing handcrafted tables and chairs for a number of years. The company was operating at a profit due to inexpensive labor costs and “the area had a good supply of timber” (University of Phoenix, 2012, para. 1) to produce the handcrafted furniture. The company was prospering without any worries. In 1990, the market shifted and Guillermo began facing challenges in the businessdue to two main factors. One was an overseas furniture business moving into the area. This ompeting company uses high tech methods to produce their furniture to “exact specification” (University of Phoenix, 2012 para 2) at reasonable prices. This was unlike Guillermo’s prices which are a little higher due to their handcrafted technique. This meant the new company could produce furniture faster and cheaper than Guillermo’s company The second factor was the awakening of the laid back relaxed atmosphere in the Sonara community. This was due to the result of one of the largest retailer in the nation’s headquarters moving a few miles down the road, “and its influence had expanded considerably” (University of Phoenix, 2012 para 2). With the new company came more jobs which meant more people moved...
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...Finance theory and Financial strategy Strategic Planning means several things. But it certainly is a part of the decision-making in resource management of the business benefits. Finance theory has significant advantages in understanding the function of capital markets, the valuation of real assets and financial assets. Discounted cash flow analysis(DCF) is a tool that derived from finance theory which has been widely used. However finance theory also has little effect on strategic planning and there are three differences between financial theory and strategic planning: 1. Traditional financial theory and strategic planning might have some differences in language and culture. 2. Discounted cash flow analysis might be used in an incorrect way of strategy therefore it is not acceptable in terms. 3. Discounted cash flow analysis might fail to apply a strategic, even if it is used properly. The most relevant financial concepts in strategic planning is firms’ capital investment decisions and it is also a critical component of “financial theory”. The theory is focused on cash flow and return on the investment. The tool used in investment decisions is net present valued (NPV) which was calculated from present valued minus required investment or which was reduced to discounted cash flow formula because the net present value is a matter of cash flow that will gain in the future. [pic] ...
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