Professional Documents
Culture Documents
Capital Budgeting
A firms decision to invest its current funds most efficiently in the longterm assets in anticipation of an expected cash flow benefits over a series of years Importance: Influence the firms growth Affect the risk of the firm Involve commitment of large funds Irreversibility Complexity of decision making Investment decisions influence firms value Firms value will increase if investment is profitable & adds to shareholders wealth
AN INVESTMENT WILL ADD TO SHAREHOLDERS WEALTH IF IT YIELDS BENEFITS AS PER THE HURDLE RATE/DISCOUNT RATE (PRINCIPLE RELATED TO INVESTMENT DECISION)
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& Diversification
Replacement
& Modernization
Also,
Mutually
Basic Principles
Focus on Cash Flows Measure Cash flows on Incremental Basis Exclude Financing Costs Treat inflation Consistently
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Evaluation Criteria
Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Terminal Value Method (TV)
Described as the summation of the present value of cash proceeds in each year minus the summation of present values of the net cash outflows in each year Following steps are involved:
Cash
flows to be forecasted Appropriate discount rate to be identified PV of cash flows to be calculated NPV should be found out; Project should be accepted if NPV>0
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Ct NPV C0 n 1 t 1 k
Where C1, C2..represent net cash inflows in the year 1,2,n; k is the cost of capital, C0 is the initial cost of investment
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Example : NPV
Assume that Project X costs Rs. 2500 now and is expected to generate year end cash inflows of Rs. 900, 800, 700, 600 and Rs. 500 in years 1 through 5. the opportunity cost of capital is 10%. Calculate the NPV of the project. Should the project be accepted?
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Time Value Measure of true profitability Value Additive Shareholder Wealth Maximization
Cash Flow estimation Discount rate Mutually exclusive projects ( details to be studied later ) Ranking of Projects
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