Capital Budgeting – the process of evaluating and selecting
long-term investments that are consistent with the firm’s
goal of maximizing owner wealth. (capital and operating
expenditures)
- Being used to accept a return of project
Capital expenditures – an outlay of funds by the firm that is
expected to produce benefits over a period of time greater
than 1 yr.
- Initial outflow/investment you will get benefits,
incremental inflows (long period of time)
Operating expenditures – an outlay of funds by the firm
resulting in benefits received within 1 yr.
- Initial outflows and acquire benefits or incremental
inflows in a short period of time.
Capital budgeting process – five distinct but interrelated
steps: (dealing how you deal with projects)
- Proposal generation – creation of project proposal
(manager)
- Review and analysis – assessment of
appropriateness or proposal
- Decision making – authorization of capital
expenditures of the business.
- Implementation – actual implementation of proposal
- Follow up – monitoring of costs
Independent projects – projects whose cash flows are
unrelated or independent of one another; the acceptance of
one does not eliminate the others from further consideration.
Mutually exclusive projects – project compete with one
another so that acceptance of one eliminates from further
consideration all other projects that serve a similar function.
Unlimited funds – the financial situation in which a firm is
able to accept all independent projects that provide an
acceptable return.
Capital rationing – financial situation in which a firm has only
a fixed number of dollars available for capital expenditures.
Accept-reject proposal – the evaluation of capital
expenditures proposals to determine whether they meet the
firm’s minimum acceptance criterion. (decision making)
Ranking approach – the ranking of capital expenditures
projects on the basis of some predetermined measure, such
as the rate of return. (setting the priorities)
Conventional cash flow patterns – An initial outflow followed
only by a series of inflows.
Nonconventional cash flow pattern – An initial outflow
followed by a series of inflows and outflows.
Conventional – use in deciding a project or decision making
of a project.
Capital expenditures – Expansion, replacement, renewal
(alternatives)
Major cash flows components:
Initial investment – Cash outflow for a proposed project at
year zero.
Operating cash flows – incremental after-tax cash inflows
resulting from project implementation or project being
implemented.
Terminal cash flows – after-tax non-operating cost occuring
in the final year of the project.
Sunk cost – outlays that have already been made and
therefore have no effect on the cash flows relevant to a
current decision. (can’t affect the decision making)
Opportunity cost - cash flows that could be realized from the
best alternative use of assets.
Book value – strict accounting value of an assets
Initial investment – accumulated depreciation
Cost-residual value/life
Payback period – amount of time required for a firm to
recover its initial investment.
Net present value – technique found by subtracting a
projects initial investment from the present value.
CAPITAL ASSET PRICING MODEL (CAPM)
Kj = RF + (bj x (km - rf))
KJ = required return on asset
RF – risk free rate of return
BJ – beta coefficient
KM – Market return
Sensitivity analysis – use of several possible return - Commonly measured as cash distributions during
estimates to obtain sense of variability among outcomes the period plus the change in value, expressed as
percentage of the beginning of period investment
CAPM (Capital asset pricing model) – the basis theory that
value.
links nondiversifiable risks and returns for all assets
- Used to understand the basis risks and return
trade-offs in all types of financial decisions
Diversifiable/unsystematic risk – portion of assets risks that
is associated with random causes that can be eliminated
through diversification.
Diversification – spreading out of assets to avoid the risks
and loss.
Ex. Firm specific events, strikes, lawsuit, regulatory actions,
loss of key accounts
Non-diversifiable/systematic risk – attributable to market
factors that affects all firms. It can be eliminated through
diversification.
- Fortuitous events Corporate bonds – long term debt instrument indication
that a company borrowed a certain amount of money.
Ex. War, inflation, Internal Incidents, Political events
Cash conversion cycle – amount of time a firm’s
The measurement of NDR is important in selecting assets
resources is tied up.
with the most desired risk and return characteristics.
Operating cycle – time from the beginning of
Beta Coefficient – an index of the degree of movement of
production, to collection of cash from sales.
assets return in response to a change in the market return.
Economic order quantity – technique used to determine
- Beta’s for actively traded stocks can be obtained
an items optimal order size to minimize the order and
from variety of purposes, but you should
carrying costs.
understand how they are derived and interpreted
and how they are applied to portfolio. Reorder point – point at which to reorder an inventory.
Portfolio – group of individual assets
Note: To maximize the share price the financial manager
must learn to access to key determinants the risks and
returns.
- Each financial position presents certain risk and
return characteristics and unique combination of
these characteristics has an impact on share price.
Risk – is a chance of financial loss.
- Some risks affect both financial managers and
shareholders
Note: both managers and shareholders must access those
and other risks as they make investment decisions.
Return – the total gain or loss on an investment over a given
period of time.