Capital Budgeting

Is the planning process used to

determine whether an
organization's long term
investment such as new
machinery, replacement of
machinery, new plants, new
products, and research
development projects are worth
the funding of cash through the

Strategic Business Plan

A long term plan that outlines in
board terms the firms basic needs
for the next five years.

Capital Expenditures
money

spent by a business or
organization on acquiring or
maintaining fixed assets, such as
land, buildings, and equipment

Factors in Analyzing Capital

Expenditures
1)

Replacement: Needed to
continue current operation One
Categories consists of capital
expenditures to replace worn-out
or damage equipment required in
the production of profitable
products

Factors in Analyzing Capital

Expenditures
2) Replacement: Cost Reduction
This category includes
expenditures to replace
serviceable but obsolete
equipment and thereby lower the
costs.

Factors in Analyzing Capital

Expenditures
3) Expansion of Existing Products
or Markets These are
expenditures to increase output of
existing products or to expand
retail outlets or distribution
facilities in market now being
served.

Factors in Analyzing Capital

Expenditures
4) Expansion into new products or
markets These investments
relate new products or
geographical areas involve
strategic decision that could
change the fundamental nature of
the business

Factors in Analyzing Capital

Expenditures
5) Safety and/or environmental
projects expenditures necessary
to comply with government, labor
agreements, or insurance policy
terms fall into this categories.

Factors in Analyzing Capital

Expenditures
6) Other Projects This catch all
includes items such as office
buildings, parking lots and
executives aircrafts.

Factors in Analyzing Capital

Expenditures
7) Mergers In a merger one firms
buys another one. Buying a whole
firm is different from buying a
assets such as machinery on
investments.

Net Present Value

A method of ranking investments
proposal using the NPV. Which is
equal to the present value of the
projects free cash flows discounted
at the cost of capital.

Net Present Value

NPV

= CF0 + + + +

= + CF0

Net Present Value

Data on Project S and L
A

WACC for both Projects

10%
Initial
Cost

Total
Inflows

Years

$1000

$500

$400

$300

$100

$1,300

$1000

$100

$300

$400

$675

$1,475

Net Present Value

R= 10%
Project S

0
$1000
$454.55
$330.58
$225.39
$68.35

NPV S

$78.82

NPV L

$100.40

1
$500

2
$400

3
$300

4
$100

Internal Rate Return

Is a metric used in capital
budgeting measuring the
profitability of potential
investments. Internal rate of
return is a discount rate that
makes the net present value (NPV)
of all cash flows from a particular
project equal to zero.

Internal Rate Return

NPV

= CF0 + + + +

= + CF0

Internal Rate Return

R= 10%
Project S

0
$1000

1
$500

2
$400

$436.72
$305.16
$199.91
$58.20
$00.0
IRR S

14.489
%

NPV at a discount rate of

14.489%.

3
$300

4
$100