...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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...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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...Project management life cycle 2.1: Scoping the project 2.2: Planning 2.3: Launching the plan 2.4: Monitoring and controlling 2.5: Closing out the project 3. Project manager skills and competencies 3.1: Classifying Project Managers 3.2: Skills and competencies 3.3: Business Achievement Competencies 3.4: Problem-Solving Competencies 3.5: Influence Competencies 3.6: People Management Competencies 3.7: Self Management Competencies, 4 Management organization/ organization structure 4.1: Pure Functional structure o Advantages and disadvantages 4.2: Pure Project Structure o Advantages and disadvantages 4.3: Matrix structure o Advantages and disadvantages 5. Scheduling 5.1: Precedence analysis 5.2: Gantt Charts 5.3: PERT / CPA 6. Budgeting 6.1: Introduction to Budgeting 6.2: Types of budgeting 6.3: Budgeting Approaches a. Top...
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...Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 – Business Economics and Financial Mathematics) Y O Lam Capital budgeting assists decision makers in a company evaluate multiple investments of the company’s capital. Capital budgeting is used to plan for the acquisitions of other companies, for the development of new product lines of business, for the expansion of the existing production plants or for the replacement worn-out equipment, and in planning decisions on whether or not to enter a new market line, whether to buy or rent production facilities, and any other investment project resulting in costs and revenues that are spread over a number of years. Capital budgeting is the method used to assess a major investment or to see whether one option is better than another. There are several capital budgeting methods, each with advantages and disadvantages. In this article, we discuss the basic principle and the advantages and disadvantages of using the net present value technique and the internal rate of return technique. Net present value (NPV) method When using the net present value method of capital budgeting, one of most important factors is the estimation of net cash flows from an investment. The net cash flow is the difference between cash outflows and cash inflows over the life of the investment. First, cash flows should be calculated on an incremental basis, and include changes in operating cash flows and changes in...
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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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...Paper Elizabeth Scott BBA/3301 January 13, 2013 Nchacha Etta Capital Budgeting When evaluating capital budgeting projects, the internal rate of return (IRR) and the net present value (NPV) methods are two major approaches used. IRR and NPV are the most widely used in capital budgeting. One other approach is the profitability index (PI) is essentially a variation on the NPV method. A question might be if these always give the same solutions to the problems. The answer here is no. This paper will explore these different capital budgeting techniques. This paper will also compare and contrast each of the techniques with an emphasis on comparative strengths and weaknesses. The net present value (NPV) applies to the analysis of projects. Calculate the present value of each of a project’s cash flows and add them together, using the net present value technique. This gives the result of the net present value of the project, usually referred to as the NPV (Lasher, 2011). A project’s net present value is the new effect that the undertaking is expected to have on the value of the firm. A capital spending program which maximizes the NPV of projects undertaken will contribute to maximizing shareholder wealth. According to Lasher (2011), it is the direct link to shareholder wealth maximization that makes MPV the most theoretically correct capital budgeting technique. The internal rate of return, instead of comparing present value dollar amounts,...
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...International is fast growing supplier of food produces. Analysts project the following free cash flows (FCFs) during the next 3 years, after which is expected to grow at a constant 7% rate. What is ABC terminal or horizon, value? FCF * 1+g)/ WACC - g = 40(1.07) / (0.13 - 0.07) =42.80 / 0.06 =$713.33 What is the firm value total today? 20/1.13¹+ 30/1.13² + 40/1.13³+ Terminal Value 713.33/1.13³ = $563.29 Suppose ABC has $100 million of debt and 10 million shares of stock outstanding. What is your estimate of the current price per share? 3. a) Klose Outfitters Inc. believes that its optimal capital structure consists of 60% common equity and 40% debt, and its tax is 40%. Klose must raise additional capital to fund its upcoming expansion. The...
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...Capital Budgeting One of the most important decisions a financial manager can make involves capital budgeting. Capital budgeting is used to determine which fixed assets should be purchased. The purchasing of fixed assets is a form of a long-term investment. Allocating funds in the capital account is a form of capital budgeting. A financial manager will determine if the purchase of a capital asset or fixed asset is worth more over that assets life then it is for the cost to purchase it. In other words, they make sure that the asset would get the amount it cost plus a profit in return. Financial managers cannot seem to agree on a specific method that works better than the other when it comes to estimating and budgeting. Even in the world of academia, the determination to which method is more accurate or desirable is not certain. Financial managers and academics both have their own theories, however neither seem to agree. To determine if an investment is worth the cash to invest in, one of the ways a financial manager can determine profitability is that they will look at the investments net present value. The amount the investment would cost to payback each year and with how long it would take to pay for the investment may change the financial manager’s mind with if it is a worthy investment. The assets that are invested in are determined by the company’s business. A new building, large equipment, new software or investing into new products or ideas are examples of items...
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...Case Study UNIT VIII – Capital Budgeting Techniques Jason Morris BBA 3301-12L-9, Financial Management Columbia Southern University February 28, 2015 Capital Budgeting Techniques This paper will explore the various method or techniques of capital budgeting as well as compare and contrast their strengths and weaknesses. Capital budgeting is the process used by organizations to make decisions about whether long-term investments worthiness or capital expenditures are worth pursuing (Baker, 2011). In simple terms, it is the process of planning, analyzing, selecting, and managing capital investments (Baker, 2011). Although there are several techniques available for evaluating capital budgeting for projects acceptance, the best techniques identify the amount, the time value, and the risk factor of a project’s cash flows (Baker, 2011). Four of the more popular and most useful techniques that this paper will focus on are payback period, net present value (NPV), internal rate of return (IRR), and profitability index (IP). The first of the four techniques to review is the payback period method. Referred to as the “breakeven” point, the payback period technique is known as the simplest of the four as its only consideration is the length of time it will take to repay the initial investment (Mian, 2011). When considering independent projects the rule of acceptance is, “an acceptable project’s payback period must be less than that policy...
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...CAPITAL BUDGETING DECISION 1. Meaning Capital budgeting denotes situation where funds are invested immediately and returns are expected after a year. In growing orgnisation capital budgeting is more or less continuous process and it is carried out by top management. The role of any Finance Manager is to critically evaluate proposal, evaluation of alternative proposal and select best one. The following are the some of the cases where heavy capital investment may be necessary. A) Replacement of fixed assets: - To replace old Assets. To buy Asset with latest technology. B) Expansion: - It means increase in production capacity to meet additional demand. C) Research and Development: - It is required for those industry where technology in changing rapidly. D) Diversification: - To set up factories, to fulfill need of various markets. To reduce dependency on one market E) Miscellaneous: - To meet legal norms, such as investment in pollution control equipment. 2. Features and significance of capital budgeting Capital budgeting includes investment for long firm funds for long term and their utilisation. Capital budgeting decision affects profitability of firm. Therefore these decisions are very important. A wrong decision taken by finance manager may affect firm’s profitability. The relevance and significance of capital budgeting may be stated as follows. A) Involvement of heavy funds: - Capital budgeting decision requires large amount of capital...
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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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...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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...Evident within the analysis of financial management is the goal of maximising shareholder wealth. Pertaining to this goal is the methodology of capital budgeting, referred to as Net Present Value analysis(NPV). This concept evaluates a capital investment project measuring the difference between its cost and the present value of its expected cash flows (Parrino et al. 2014, p.339). More simply, the NPV tell us the amount by which the benefits from a capital expenditure exceed its costs (Parrino et al. 2014, p.339). Along with any valuation method for a capital project are associated advantages and disadvantages essential to determining its relevance when compared with other methods of analysis. The advantages of NPV include, but are not limited to: the inclusion and importance of the 'time value of money (Accounting-Management 2014),' consideration of cash flows before, during and after a business venture, consistency with financial management goals and the high priority of profitability and risk involved in capital investment (Accounting-Management 2014). The inclusion of the time value of money is the most notable advantage of NPV supported by the notion, 'a dollar today is worth more than a dollar in the future (Investopedia 2014).' Present currency holds more value due to three reasons, accruing interest on investments, future money is subject to inflation and finally there is always the risk of not receiving promised money (Investopedia 2014). An organisation is unlikely...
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...1) What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates? The term “risk”, in the context of capital budgeting, means the uncertainty about the future profitability of the plan. We should understand if the taking on the project will rise both firm and stockholders’ risk. About the quantification, we should mainly use statistical analysis, but also historical data can be used and risk analysis in capital budgeting is usually focused on subjective judgments. 2) What are the three types of risk that are relevant in capital budgeting? How is each of these risk types measured, and how do they relate to one another? How is each type of risk used in the capital budgeting process? Three main kind of risk are present in capital budgeting: - Stand-alone risk - Corporate risk - Market risk. The first one (Stand-Alone Risk) concerns the project’s risk if it is the only asset in the firm and no shareholders are there. It passes over both firm and shareholders’ diversification and it is computed by Sigma or CV of NPV, IRR or MIRR. The second risk (that is Corporate Risk) concerns the project’s effect on corporate earnings stability. It also considers other activities of the firm (better knows as diversification within firm) and it depends on project’s sigma and the correlation (ρ) with...
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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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