Chapter 10 : The Fundamentals of Capital Budgeting
Added on 2020-05-28
34 Pages7926 Words150 Views
Finance
|
|
|
CHAPTER 10The Fundamentals of Capital BudgetingLearning Objectives1.Discuss why capital budgeting decisions are the most important decisions made by a firm’smanagement.2.Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions, and be able to calculate the NPV for a capital project. 3.Describe the strengths and weaknesses of the payback period as a capital expenditure decision-making tool, and be able to compute the payback period for a capital project.4.Explain why the accounting rate of return (ARR) is not recommended for use as a capital expenditure decision-making tool.5.Be able to compute the internal rate of return (IRR) for a capital project, and discuss the conditions under which the IRR technique and the NPV technique produce different results. 6.Explain the benefits of a postaudit review of a capital project.I.Chapter Outline10.1 An Introduction to Capital BudgetingA.The Importance of Capital BudgetingCapital budgeting decisions are the most important investment decisions made by management.Prepared by Jim Keys1
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 own business. No matter what type you started, you would have to answer the following three questions in some form or another: 1.What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need? 2.Where will you get the long-term financing to pay for your investment? Will you bring inother owners or will you borrow the money? 3.How will you manage your everyday financial activities such as collecting from customers and paying suppliers?Capital BudgetingThe first question concerns the firm's long-term investments. The process ofplanning and managing a firm's long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more tothe firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset. Regardless of the specific investment under consideration, financial managers must be concerned with how much cash they expect to receive,when they expect to receive it, and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be, by far, the most important things we will consider.B.Sources of InformationMost of the information needed to make capital budgeting decisions is generated internally, beginning likely with the sales force.Then the production team is involved, followed by the accountants.All this information is then reviewed by the financial managers, who evaluate the feasibility of the project.Prepared by Jim Keys2
C.Classification of Investment ProjectsCapital budgeting projects can be broadly classified into three types: (1) independent projects; (2) mutually exclusive projects; and (3) contingent projects.1.Independent ProjectsProjects are independent when their cash flows are unrelated.If two projects are independent, accepting or rejecting one project has no bearing on the decision on the other.Prepared by Jim Keys3
2.Mutually Exclusive ProjectsWhen two projects are mutually exclusive, accepting one automatically precludes the other.Mutually exclusive projects typically perform the same function.3.Contingent ProjectsContingent projects are those in which the acceptance of one project is dependent on another project.There are two types of contingency situations:Projects that are mandatoryProjects that are optionalD.Basic Capital Budgeting TermsThe cost of capital is the minimum return that a capital budgeting project must earn for it to be accepted.It is an opportunity cost since it reflects the rate of return investors can earn on financial assets of similar risk.Capital rationing implies that a firm does not have the resources necessary to fund all of the available projects. It implies that funding needs exceed funding resources. Thus, the available capital will be allocated to the set of projects that will benefit the firm and its shareholders the most. Prepared by Jim Keys4
Capital budgeting criteria checklistDoes the method account for the time value of money (TVM)?Are all cash flows included?Can we adjust for differential project risk?Is there a decision rule?Can we measure the effect on the value of the firm?10.2Net Present ValueIt is a capital budgeting technique that is consistent with the goal of maximizing shareholder wealth.The method estimates the amount by which the benefits or cash flows from a project exceedsthe cost of the project in present value terms.A.Valuation of Real AssetsValuing real assets calls for the same steps as valuing financial assets.Estimate future cash flows.Determine the investor’s cost of capital or required rate of return.Calculate the present value of the future cash flows.However, there are some practical difficulties in following the process for real assets.First, cash flow estimates have to be prepared in-house and are not readily available as they are for financial assets in legal contracts.Second, estimates of required rates of return are more difficult than it is for financial assets because no market data is available for real assets.B.NPV—The Basic ConceptPrepared by Jim Keys5
The present value of a project is the difference between the present value of the expectedfuture cash flows and the initial cost of the project.Accepting a positive NPV project leads to an increase in shareholder wealth, while accepting a negative NPV project leads to a decline in shareholder wealth.Projects that have an NPV equal to zero imply that management will be indifferent between accepting and rejecting the project.The Basic Idea – The NPV measures the increase in firm value, which is also the increasein the value of what the shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our goal – making decisions that will maximize shareholder wealth.Estimating Net Present Value: Discounted cash flow (DCF) valuation – finding the market value of assets or their benefits by taking the present value of future cash flows byestimating what the future cash flows would trade for in today’s dollars.The cost of the project must be determined.Cash flows from the project are estimated.The riskiness of the projected cash flows is determined, so the appropriate rate of return is used to discount the cash flows.Cash flows are discounted to their present value to obtain an estimate of the asset’s value to the firm.The present value of the future expected cash flows is compared with the requiredoutlay, or cost. If the asset’s value exceeds its cost, the project should be accepted;otherwise, it should be rejected. Alternatively, the project’s expected rate of returnis compared with the rate of return considered appropriate for the project.If a firm identifies an investment opportunity with a present value greater than itscost, the firm’s value will increase. There is a very direct link between capitalbudgeting and stock values. The more effective the firm’s capital budgetingprocedures, the higher the price of its stock.C.Framework for Calculating NPVThe NPV technique uses the discounted cash flow technique.Our goal is to compute the net cash flow (NCF) for each time period t, where NCFt= (Cash inflows – Cash outflows) for the period t.A five-step approach can be utilized to compute the NPV.Prepared by Jim Keys6
1.Determine the cost of the project.Identify and add up all expenses related to the cost of the project.While we are mostly looking at projects whose entire cost occurs at the start of the project, we need to recognize that some projects may have costs occurring beyond the first year also.The cash flow in year 0 (NCF0) is negative, indicating a cost.2.Estimate the project’s future cash flows over its expected life.Both cash inflows (CIF) and cash outflows are likely in each year of the project. Estimate the net cash flow (NCFt) = CIFt – COFt for each year of the project.Remember to recognize any salvage value from the project in its terminal year.3.Determine the riskiness of the project and the appropriate cost of capital.The cost of capital is the discount rate used in determining the present value of the future expected cash flows.The riskier the project, the higher the cost of capital for the project.4.Compute the project’s NPV.Determine the difference between the present value of the expected cash flows from the project and the cost of the project.5.Make a decision.Accept the project if it produces a positive NPV or reject the project if NPV is negative.,k)(1NCFNPVn0tttwhere: Prepared by Jim Keys7
NCFt = Net cash flow cash inflows – cash outflows) in period t, where t = 1, 2, 3,..., nk = The cost of capitaln = The project’s estimated lifeExample - Compute the Net Present Value (NPV) given a required return of 12% and the following netcash flows:YearNCFt0($20,000)1$6,0002$7,0003$8,0004$5,0005$4,000543210)12.1(000,4)12.1(000,5)12.1(000,8)12.1(000,7)12.1(000,6)12.1(000,20NPV71.269,2$59.177,3$24.694,5$36.580,5$14.357,5$000,20$NPV$2,079.0404.079,22$000,20$NPV (Since the NPV>0, the project should be accepted).Excel Solution (in class)(note on Excel NPV function)Calculator Solution (in class)What is the NPV if the required return is 17%?543210)17.1(000,4)17.1(000,5)17.1(000,8)17.1(000,7)17.1(000,6)17.1(000,20NPV44.824,1$25.668,2$96.994,4$59.113,5$21.128,5$000,20$NPV$270.5545.729,19$000,20$NPV (Since the NPV<0, the project should be rejected).Note: It is not the rather mechanical process of discounting the cash flows that is important. Once we have the cash flows and the appropriate discount rate, the required calculations are fairly straightforward. The task of coming up with the cash flows and the discount rate in the first place is much more challenging.NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. Prepared by Jim Keys8
End of preview
Want to access all the pages? Upload your documents or become a member.
Related Documents
Corporate Financial Management Assignment Capital Budgetinglg...
|12
|3009
|181
Corporate Finance Definitionlg...
|6
|1232
|112
Capital Budgeting Analysis of ‘Real Time Translator’ project of Auditizz Electronicslg...
|10
|2053
|64
CAPITAL BUDGETING TECHNIQUES Payback Period (PBP) calculates thelg...
|3
|434
|322
Business Decision Makinglg...
|9
|1530
|404
Evaluate the Usefulness of Different Methods and Differenceslg...
|9
|1404
|95