important investment decisions made by management. • The goal of these decisions is to select capital projects that will increase the value of the firm. • Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed. • Capital budgeting techniques help management to systematically analyze potential business opportunities in order to decide which are worth undertaking. |Imagine you were to start your
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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 and analyze the relevant cash flows of the investment proposal identified in Step 2 4. Determine the fiscal feasibility of each proposal in Step 3 5. Choose the project
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WEEK 2 NPV, PBP, IRR, EAC( equivalent annual cash flow) NPV: If NPV>0, accept the project [which are expected to add value to the firm], otherwise don’t bother. Reminders Rule 1: Only cash flow is relevant Cash flow ≠ accounting income •In an income statement, profit is shown as it is earned rather than when the company and its customers get around to paying their bills. •Cash outflows are sorted into two categories: 1) current expenses, deducted when calculating income; and 2)
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of planning expenditures on assets whose cash flows are expected to extend beyond one year. By convention, the process is referred to as financial asset valuation when it deals with financial, or derivative assets, and as Capital Budgeting when it deals with real assets. Comparing processes: Real Assets Financial assets Determine the cost of the investment project Determine the price that must be paid for the asset Estimate expected cash flows including salvage value Determine future
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2. Define an “Incremental cash flow” as the term is used in capital budgeting 3. Define the payback period method in capital budgeting and state the payback period decision rule. 4. What is the payback period of the following project? Initial Investment: $60,000 Projected life: 7 years Net cash flows each year: $14,000 5. Define the discounted payback period method in capital budgeting and state the payback period decision rule. 6. What is the discounted
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3 4 | CASH FLOW -1,000,000 450,000 350,000 300,000 250,000 | COST OF FORMULAR = N=0NCFn1+in CAPITAL – 8% (1,000,0001+0.08) + (450,0001+0.08) + (350,000(1+0.08)) + (300,000(1+0.08)) + (250,000(1+0.08)) = 138,642.39 >0 INTERNAL RULE OF RETURN FORMUA – 0= n=0NCFn1+IRRn IRR= 14.79% SIMPLE PAYBACK YEAR 0
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Management Concept Summary Algebra Solving Linear Equations in One Variable Manipulate the equation using Rule 1 so that all the terms involving the variable (call it x) are on one side of the equation and all constants are on the other side. Then use Rule 2 to solve for x. Rule 1: Adding the same quantity to both sides of an equation does not change the set of solutions to that equation. Rule 2: Multiplying or dividing both sides of an equation by the same nonzero number does not change the set
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2. Define an “Incremental cash flow” as the term is used in capital budgeting 3. Define the payback period method in capital budgeting and state the payback period decision rule. 4. What is the payback period of the following project? Initial Investment: $60,000 Projected life: 7 years Net cash flows each year: $14,000 5. Define the discounted payback period method in capital budgeting and state the payback period decision rule. 6. What is the discounted
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projects simply by inspecting the cash flows? Analyzing the sum and the excess of cash flow can give the business an order of the most profitable investments; however it does not give the full details that are important to determining true profitability. As one can see from the charts, Project Number 3 has the highest sum of cash-flow benefits and excess of cash flow, but the payback is not accomplished until the 15th year. Other Projects may not have a high sum of cash-flow; however the initial payback
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simply by inspecting the cash flows? Analyzing the sum and the excess of cash flow can give the business an order of the most profitable investments; however it does not give the full details that are important to determining true profitability. As one can see from the charts, Project Number 3 has the highest sum of cash-flow benefits and excess of cash flow, but the payback is not accomplished until the 15th year. Other Projects may not have a high sum of cash-flow; however the initial payback
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