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Capital Budgeting

Capital Budgeting

Capital Budgeting is the process


of evaluating and selecting longterm
investments
that
are
consistent with the firms goal of
maximizing owners wealth.

Motives For Capital Expenditure


Capital Expenditure: An outlay of
funds by the firm that is expected to
produce benefits over a period of time
greater than one year.

Operating Expenditure: An outlay of


funds by the firm resulting in benefits
received within one year.

Motives For Capital


Expenditure
Companies make capital expenditures for
many reasons. The basic motives for
capital expenditures are
to expand operations,
to replace or renew fixed assets,
to obtain some other, less tangible benefit
over a long period.

Capital budgeting process: Five


distinct but interrelated steps: proposal
generation, review and analysis, decision
making, implementation, and follow-up.

Steps in process:
1.Proposal generation
2.Review and analysis
3.Decision making
4.implementation
5.Follow-up

Basic Terminology
Independent versus mutually Exclusive Projects
Independent projects: Projects whose cash
flows are unrelated to one another; the
acceptance of one does not eliminate the others
from further consideration.
Mutually exclusive projects: Projects that
compete with one another, so that the acceptance
of one eliminates from further consideration all
other projects that serve a similar function.

Unlimited funds versus


capital rationing
Unlimited funds: The financial situation in
which a firm is able to accept all
independent projects that provide an
acceptable return.

Capital rationing: The financial situation


in which a firm has only a fixed number of
dollars available for capital expenditures,
compete for these dollars.

Accept-reject versus
ranking Approaches
Accept-reject approach: The
evaluation of capital expenditure
proposals to determine whether they meet
the firms minimum acceptance criterion.

Ranking Approach: The ranking of


capital expenditure projects on the basis
of some predetermined measure, such as
the rate of return.

Capital Budgeting
Techniques
Payback period:
The amount of time required for a firm
to recover its initial investment in a project,
as calculated from cash inflows.

Pros and Cons of payback


period
Merits
Easy to evaluate small project
Simple to compute
Gives implicit consideration to the timing
of cash flow
Can be viewed as a measure of risk
exposure

Demerits
Do not consider the time value of money.
Cannot be specified in light of the wealth
maximization goal.

Relevant Cash Flows and payback


periods for DEyaman Enterprises
projects
Project gold Project silver
Initial Investment
Year

$ 50000

$ 50000

Operating cash inflows

$5000

$40000

5000

2000

40000

8000

10000

10000

10000

10000

3 years

3 years

Payback period

Net Present Value (NPV)

A sophisticated capital budgeting


technique; founded by subtracting a
projects initial investment from the
present value of its cash inflows
discounted at a rate equal to the firms
cost of capital.

NPV and the Profitability


index
Internal rate of return (IRR):
The discount rate that equates the NPV of
an investment opportunity with
$0(because the present value of cash
inflows equals the initial investment); it is
the rate of return that the firm will earn if
it invests in the project and receives the
given cash inflows.