Capital_Budgeting by wpr1947


									 Capital Budgeting (Long Term Investment) Decisions           Chap.12 Dr. Kiani
A. What is capital budgeting?
   Capital budgeting is the series of long term planning decisions by individual
   economic units as to how much and where resources will obtained and expended
   for future use, particularly in the production of future goods and services.

B. The scope of capital budgeting encompasses:
       1. How money is acquired and from what sources?
          Sources are:
                a. Internal= Retained earnings and depreciation
                b. External= Issue bonds, debt financing, issue stocks(common &
      2. How individual capital project alternatives are identified and evaluated?
     3. How minimum requirements of acceptability are set?
            ---- cost of capital
           ------ weighted average cost of capital
 Sources                      %                Specific cost of Capital                   WACOC
   RE       $3,000,000        .3                    .10                                    .030
   DEBT      2,000,000        .20                   .15                                    .030
   C/S        4,000,000        .40                   .09                                    .036
   P/S        1,000,000         .10                   .08                                    .008
             10,000,000        1.00                                                      10.40%
   4. How final project selections are made?
   5. How post mortem are conducted?

C. Capital Investments Decisions:
                a. Expansion decisions
                b. Replacement decisions
                c. New product decisions

D. Data requirements for capital budgeting projects
               a. Expected revenues and expenditures
               b. Expected useful life
               c. Expected salvage value
               d. Expected tax benefits
               e. Expected cost of capital
               f. Actual cost of investment
E. Techniques of Capital Budgeting :
               a. Payback period
               b. Payback reciprocal
               c. Accounting Rate of Return (AROR)
               d. Net Present Value (NPV)
               e. Net Profitability Index(NPI) or Net Present Value Index (NPVI)

                  f. Adjusted Rate of Return or Internal Rate of Return (IRR)
 1. What is Payback Period?
     Number of years required to retain the original investment. That is how long it
     takes to recover the original investment.
      Major advantages: Simplicity and liquidity
      Major disadvantages:
             a. It ignores time value of money
             b. It ignores income which may be produced beyond the payback
  Rank projects using payback period by lowest payback period to highest payback
 Payback Period = (Investment)/ (Net Cash Inflows)
Net cash Inflows = Net Operating Income + Depreciation Expense
Cash inflows:
      Incremental Revenues
      Reduction in Costs
      Salvage Value
      Release of Working Capital …Working capital means ( Cash, accounts
         receivables, and inventory)
Cash Outflows:
        Initial Investment ( Including installation costs)
        Increased in Working Capital needs
        Repairs and Maintenance
        Incremental Operating Costs

  Major advantage: a. Data are readily available from accounting records.
                     b. Easy to understand and use
                     c. Ties in with Income Statement and Performance Evaluation
 Major disadvantages: it ignores time of money.
 Rank projects according to highest AROR to lowest AROR provided that lowest is
 at least equal to the cost of capital.

    NPV =Present Value of Cash Inflows – Present Value of Cash Outflows

    Decision Rule:
    a. If NPV>0, then accept the project
    b. If NPV=0, then indifference position, go no go situation
    c. If NPV< 0, then reject the project

     Rank projects according to highest NPV to lowest NPV, provided that lowest
     Major advantages:

     a. Emphasizes Cash Flows
     b. Recognizes Time Value of Money
     c. Assume Discount Rate is Reinvestment Rate
     d. Easy to Apply
Major Disadvantages:
     a. Favors Larger, Longer Project
     b. Assumes No Changes in Required Rate of Return.

                      F = P (1+i%)n
Where :
        F = future sum
        P = Principal
        i% = interest Rate
         n = # of years or period
        PV= Present Value
       PV factor= discount factor = 1/(1+i%)n
So: PV = F/(1+i%)n

 4. Profitability Index (PI) or Present Value Index (PVI)
   ( Present Value of Cash Inflows)/ ( Present Value of Cash Outflows)

 Decision Rule:
   a. If PVI > 1 , then accept the project
   b. If PVI = 1, then indifference position
   c. If PVI < 1, then reject the project
Ranking project according to highest PVI to lowest PVI ( at least = 1).


IRR is an interest rate which equates the present value of cash inflows to present
value of cash outflows, and makes NPV=0.

Calculation: a: trial and error approach or b: mathematical equation

Decision Rule:
 a. IF IRR > Cost of Capital (COC), then accept the project
 b. IF IRR = COC, then indifference position
 c. IF IRR <COC, then reject the project
Major advantages:
       a. Emphasizes Cash Flows
        b. Recognizes Time Value of Money
   c. Computes True Return of Projects
Major disadvantages:
   a. Assume IRR is the reinvestment rate
   b. Favors shorter projects.


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