...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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...Table of Contents Definition of capital budgeting 2 The Major Capital Budgeting Techniques 4 Payback Period 4 Internal Rate of Return 7 Factors Influencing Capital Budgeting 7 Need For Capital Budgeting 7 Capital budgeting project 8 References 9 Definition of capital budgeting Capital budgeting 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 the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). Planning the eventual returns on investments in machinery, real estate and new technology are all examples of capital budgeting. Management must allocate the firm's limited resources between competing opportunities (projects), which is one of the main focuses of capital budgeting. Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital. Investments should be made on the basis of value-added to the future of the corporation. Capital budgeting projects may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions. When no such value can be added through the capital budgeting process and excess cash surplus exists...
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...Introduction Capital budgeting decisions are the most important investment decisions made by management. The objective of these decisions is to select investments in real assets that will increase the value of the firm. (Kidwell and Parrino, 2009) Capital budgeting techniques help management systematically analyze potential business opportunities in order to decide which are worth undertaking. (Kidwell and Parrino, 2009) There are many techniques used in the process of capital budgeting. The most common methods are payback, discounted payback period, net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR), and modified internal rate of return (MIRR). This paper will examine each of these techniques, weighing the pros and cons of each, and determining which technique in correct in theory. Payback Period The payback period is not a sophisticated capital budgeting technique. With using the payback period for evaluating projects, a project is accepted if the payback period is below a special threshold. (Kidwell and Parrino, 2009) The payback period is defined as the number of years that it will take a project to recover the initial investment of a company. This period can be easily calculated by adding the years before cost recovery to the remaining cost to recover divided by the cash flow during the year. It is because of the simplicity of this method is the most widely preferred tool for evaluating capital projects. Outside of its...
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...Winnings-Looks Can Be Deceptive; Time Value of Money Case 7- It’s Better Late Than Never!; Retirement Planning Case 8- Paying Off That Dream House; Loan Amortization Case 9- Wake Up and Smell the Coffee!; Time Value of Money Case 10- Corporate Bonds-They Are More Complex Than You Think; Bond Analysis and Valuation Case 11- How Low Can It Go?; Application of Stock Valuation Methods Case 12- What Are We Really Worth; Valuation of Common Stock Case 13- The Lazy Mower: Is It Really Worth It?; Estimating Cash Flow-New Project Analysis Case 14- If the Coat Fits, Wear it; Replacement Project Analysis Case 15- The Dilemma at Day-Pro; Comparison of Capital Budgeting Techniques Case 16- Too Hot to Handle; Capital Budgeting Case 17- Flirting with Risk; Risk and Return Case 18- I Wish I Had a Crystal Ball; Real Options and Capital Budgeting Case 19- Can One Size Fit All?; Determining the Cost of Capital Case 20- We Are Not All Alike; Divisional Costs of Capital Case 21- Where Do We Draw the Line?: Marginal Cost of Capital and Capital Budgeting Case 22- EVA ? Does It Really Work?; Economic Value Added (EVA) Case 23- It’s Better to Be Safe Than Sorry!; Evaluating Project Risk Case 24- Look Before You Leverage; Debt Versus Equity Financing Case 25- Is It Worth More Dead or Alive?; Bankruptcy and Reorganization Case 26- Is It Much Ado About Nothing?; Dividend Policy Case 27- Timing Is Everything!; Working Capital Management Case 28- Getting Our Act...
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...com/ACC-560-WK-9-Quiz-12-All-Possible-Questions-028.htm ACC 560 WK 9 Quiz 12 - All Possible Questions TRUE-FALSE STATEMENTS 1. Capital budgeting decisions usually involve large investments and often have a significant impact on a company's future profitability. 2. The capital budgeting committee ultimately approves the capital expenditure budget for the year. 3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools. 4. The cash payback technique is a quick way to calculate a project's net present value. 5. The cash payback period is computed by dividing the cost of the capital investment by the net annual cash inflow. 6. The cash payback method is frequently used as a screening tool but it does not take into consideration the profitability of a project. 7. The cost of capital is a weighted average of the rates paid on borrowed funds, as well as on funds provided by investors in the company's stock. 8. Using the net present value method, a net present value of zero indicates that the project would not be acceptable. 9. The net present value method can only be used in capital budgeting if the expected cash flows from a project are an equal amount each year. 10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. ...
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...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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...com/ACC-560-WK-9-Quiz-12-All-Possible-Questions-028.htm ACC 560 WK 9 Quiz 12 - All Possible Questions TRUE-FALSE STATEMENTS 1. Capital budgeting decisions usually involve large investments and often have a significant impact on a company's future profitability. 2. The capital budgeting committee ultimately approves the capital expenditure budget for the year. 3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools. 4. The cash payback technique is a quick way to calculate a project's net present value. 5. The cash payback period is computed by dividing the cost of the capital investment by the net annual cash inflow. 6. The cash payback method is frequently used as a screening tool but it does not take into consideration the profitability of a project. 7. The cost of capital is a weighted average of the rates paid on borrowed funds, as well as on funds provided by investors in the company's stock. 8. Using the net present value method, a net present value of zero indicates that the project would not be acceptable. 9. The net present value method can only be used in capital budgeting if the expected cash flows from a project are an equal amount each year. 10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. ...
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...which, if any, projects or investments opportunities the organization should undertake. The task of analyzing and comparing financials is a daunting task, but when utilizing the tools of capital budgeting, the process of this type of business decision making can be quite useful. This paper will define capital budgeting and discuss some of the components of this decision making tool. It will also discuss some of the concerns that go along with Capital Budgeting. The Basics of Capital Budgeting What is Capital Budgeting? Organizations looking to expand their business through asset acquisition create a capital budget (Paden, n.d.). Capital budgets exclusively are associated with real estate, equipment and other potential assets used to evaluate asset impact and the potential benefit to the organization. Capital Budgeting is the process in which a business determines whether a project or investment venture are worth pursuing. It is the process of analyzing investment opportunities and deciding which one to accept (Berk & DeMarzo, 2014). Potential ventures are evaluated and the potential expenditures or investments are ranked. Usually, these types of business decisions are for large purchases or investments. Steps of Capital Budgeting There are seven steps involved in capital budgeting (Hofstrand, 2013). They are: 1. Identify long-term goals of the organization 2. Identify potential investment prospects for meeting long-term goals identified in Step 1 3. Estimate...
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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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...Capital Budgeting When people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. Actually, capital is the more important aspect in that it lets us know that we are evaluating a larger expenditure that will be capitalized -- in other words, depreciated over time. Remember, a capital expenditure can be many things -- a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting -- the acquisition of another entity. What is totally cool about capital budgeting is it allows you to analyze one or more projects so that you can intelligently and strategically make a decision as to which project you wish to acquire or piece of equipment you should procure. There are at least 6 capital budgeting tools that can be used in analyzing a capital expenditure (please note that the text mainly focuses on NPV and IRR) -- Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), Payback Period (PB), Discounted Payback Period (DPB), and Modified Internal Rate of Return (MIRR). Perhaps in a prior finance course, you might have learned how to calculate four of the above six tools -- NPV, IRR, PI, and PB. If not, then it will be new material for you! Now, crunching the numbers might seem by some to be the more crucial part -- and it is indeed very important. However, interpreting and analyzing the answers are just as important. Let's see if we can do this with our...
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...‘When calculating variances, we in effect ignore differences of volume of output, between original budget and actual, by flexing the budget. If there were a volume difference, it is water under the bridge by the time that the variances come to be calculated’. Variance analysis typically involves the isolation of different causes for the variation in income and expenses over a given period from the budgeted standards. So for example, if direct wages had been budgeted to cost $100,000 actually cost $200,000 during a period, variance analysis shall aim to identify how much of the increase in direct wages is attributable to: * Increase in the wage rate (adverse labour rate variance); * Decline in the productivity of workforce (adverse labour efficiency variance); * Unanticipated idle time (labour idle time variance); * More wages incurred due to higher production than the budget (favourable sales volume variance). Variance analysis highlights the causes of the variation in income and expenses during a period compared to the budget. In order to make variances meaningful, the concept of 'flexed budget' is used when calculating variances. Flexed budget acts as a bridge between the original budget (fixed budget) and the actual results. Flexed budget is prepared in retrospect based on the actual output. Sales volume variance accounts for the difference between budgeted profit and the profit under a flexed budget. All remaining variances are calculated as the difference...
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...Capital Budgeting: Capital budgeting is the process of determining whether or not an investment is worthwhile. Often companies will have several opportunities and must measure each one's potential in order to make a comparison and choose just one or a few. It is the process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. On the other hand capital budgeting 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 the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders. Capital budgeting involves allocating...
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...AN APPRAISAL OF CAPITAL BUDGETING TECHNIQUES (A CASE STUDY OF FORTHRIGHT SECURITIES AND INVESTMENT LIMITED, MARINA, LAGOS) BY OLOJOTUYI OLUFEMI O. FPA/AC/09/3-0101 BEING A PROJECT REPORT SUBMITTED TO THE DEPARTMENT OF ACCOUNTANCY SCHOOL OF BUSINESS STUDIES, THE FEDERAL POLYTECHNIC, ADO EKITI EKITI STATE IN PARTIAL FULFILLMENT OF REQUIREMENTS FOR THE AWARD OF HIGHER NATIONAL DIPLOMA IN ACCOUNTANCY DECEMBER, 2011. CERTIFICATION This is to certify that this research project was duly carried out by OLOJOTUYI OLUFEMI O. of the Department of Accountancy, School of Business Studies Federal Polytechnic, Ado Ekiti, Ekiti State and accepted as meeting part of the requirements for the award of Higher National Diploma in Accountancy. ……………………………… ……………………………. MR. UCHEFUNA D.I MRS. M. OLOWOLAJU Project supervisor H. O.D Accountancy …………………………….. …………………………….. DATE DATE DEDICATION This project work is dedicated to Almighty God and to my parent Mr. and Mrs. Olojotuyi. ACKNOWLEDGEMENT I give glory to God, for his guidance, protection and strength throughout the period of this project work. Thanks to my supervisor, Mr. Uchefuna D.I who has been of tremendous help in guiding and encouraging me through this process. Furthermore, for his serious yet gentle commitment to the completion of this...
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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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...Material Capital Budgeting – Clarification Example When people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. Actually, capital is the more important aspect because it shows you that you are evaluating a larger expenditure that will be capitalized—in other words, depreciated over time. Remember, a capital expenditure can be many things—a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting—the acquisition of another entity. What is important about capital budgeting is it allows you to analyze one or more projects so you can intelligently and strategically decide on which project you wish to acquire or which piece of equipment you should procure. There are at least six capital budgeting tools you can use in analyzing a capital expenditure: net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period (PB), discounted payback period (DPB), and modified internal rate of return (MIRR), although the textbook mainly focuses on net NPV and IRR. In a prior finance course, you might have learned how to calculate four of the six tools—NPV, IRR, PI, and PB. If not, then this will be new material for you. Crunching the numbers might seem by some to be the more crucial part—and it is indeed important. However, interpreting and analyzing the answers are just as important. See if you can do this with the six capital budgeting tool...
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