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CAPITAL BUDGETING: CAPITAL BUDGETING Meaning, Types and Importance Definition: Capital budgeting is long term planning for

r making and financing proposed capital outlays. Capital : Fixed assets used in production Budget : Plan of in- and outflows during some period Capital Budget : A list of planned investment (i.e., expenditures on fixed assets) outlays for different projects. Capital Budgeting : Process of selecting viable investment projects Definition Positioning of capital budgeting: Positioning of capital budgeting Projects: Independent : A project that has nothing to do with other projects under investigation. Example: Replace copy machine and build a new plant. Mutually Exclusive : You only need one of these alternative projects. Example: Buy IBM or Apple PC Projects The eight steps in capital budgeting: T he eight steps in capital budgeting Capital expenditure budget: Capital expenditure budget Planned allocations for acquiring capital assets. The amount of money needed to spend on capital items or fixed assets such as land, buildings, roads, equipment, etc. that are projected to generate income in the future. Capital Expenditure Budget is plan prepared for individual capital expenditure projects. Types of capital expenditure: Types of capital expenditure Capital expenditure which increases revenue It fetches additional income in future Eg: Production of new products Capital expenditure which reduces costs Helps in reducing cost of present production Eg: Purchase of improved machineries Importance of capital budgeting: Huge amount of investment Permanent and irreversible commitment of funds Long-term impact on profitability Growth and expansion Cost over runs (excessive costs if not done properly) Alternatives Multiplicity of variables Top management activity Importance of capital budgeting

Concepts of Capital Budgeting Time Value of Money The idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Also referred to as "present discounted value".

Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future. For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate. Payback Period The length of time required to recover the cost of an investment. Calculated as: All other things being equal, the better investment is the one with the shorter payback period. For example, if a project cost $100,000 and was expected to return $20,000 annually, the payback period would be $100,000 / $20,000, or five years. All other things being equal, the better investment is the one with the shorter payback period. For example, if a project cost $100,000 and was expected to return $20,000 annually, the payback period would be $100,000 / $20,000, or five years. There are two main problems with the payback period method:1) It ignores any benefits that occur after the payback period and, therefore, does not measure profitability. 2) It ignores the time value of money. Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are

generally preferred. Net Present Value (NPV) The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. Formula: NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. Internal Rate Of Return (IRR) IRR is sometimes referred to as "economic rate of return (ERR)". You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. Discounted Cash Flow (DCF) A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Calculated as:

There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you'd receive from an investment and to adjust for the time value of money. DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, a terminal value approach is often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on. Profitability Index An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as: A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project. NPV and IRR Methods: Possible Decision Conflicts An accept/reject "conflict" occurs when NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept" Note: When projects are independent, no accept/reject conflict will arise

A ranking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR. Note: Ranking conflicts are unusual but can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects Ranking conflicts arise because of: 1) Timing differences in incremental cash flows 2) Magnitude differences in incremental cash flows When a conflict arises among mutually exclusive projects, pick the one with the highest NPV

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Capital budgeting
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Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new

products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1] Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return Payback period Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity Real Options Valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Contents
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1 Net present value 2 Internal rate of return 3 Equivalent annuity method 4 Real options 5 Ranked Projects 6 Funding Sources 7 External links and references

[edit]Net present value


Main article: Net present value Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see alsoFisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is greatly affected by

the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

[edit]Internal rate of return


Main article: Internal rate of return The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV [citation
needed]

, although they should be used in concert. In a budget-constrained environment, efficiency measures

should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

[edit]Equivalent annuity method


Main article: Equivalent annual cost

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.Y

[edit]Real options
Main article: Real options analysis Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.

[edit]Ranked Projects
The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

[edit]Funding Sources
When a corporation determines its capital budget, it must acquire said funds. Three methods are generally available to publicly traded corporations: corporate bonds, preferred stock, and common stock. The ideal mix of those funding sources is determined by the financial managers of the firm and is related to the amount

of financial risk that corporation is willing to undertake. Corporate bonds entail the lowest financial risk and therefore generally have the lowest interest rate. Preferred stock have no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects.The Internal Rate of Return is very important.