Mark Lester SamonteMark Lester Samonte

OVERVIEW OF CAPITAL BUDGETING

Capital Budgeting Capital Budgeting

The process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owners’ wealth.

Capital Expenditure Capital Expenditure

An outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.

Operating Expenditure Operating Expenditure

An outlay of funds by the firm resulting in benefits received within 1 year.

Capital Budgeting Process Capital Budgeting Process

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

STEPS IN THE PROCESS STEPS IN THE PROCESS

Thecapital budgeting process consists of five distinct but interrelated steps:

1. Proposal generation. Proposals for new investment projects are made at all levels within a business organization and are reviewed by finance personnel. Proposals that require large outlays are more carefully scrutinized than less costly ones.

2. Review and analysis.Financial managers perform formal review and analysis to assess the merits of investment proposals.

3. Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often plant managers are given authority to make decisions necessary to keep the production line moving.

4. Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases.

5. Follow-up. Results are monitored, and actual costs and benefits are com- pared with those that were expected. Action may be required if actual out- comes differ from projected ones.

 

Independent versus Mutually Exclusive Projects Independent versus Mutually Exclusive Projects Independent Projects - Projects whose cash flows

are unrelated to (or independent of) 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 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, and numerous projects compete for these dollars.

Accept–Reject versus Ranking Approaches Accept–Reject versus Ranking Approaches

Accept–Reject Approach - The evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion.

 Ranking Approach - The ranking of capital

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

ApplicationApplication

 

CAPITAL BUDGETING TECHNIQUES

 

CAPITAL BUDGETING TECHNIQUES

Payback PeriodPayback Period

The amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

DECISION CRITERIADECISION CRITERIA

When the payback period is used to make accept–reject decisions, the following decision criteria apply:

• If the payback period is less than the maximum acceptable payback period, accept the project.

• If the payback period is greater than the maximum acceptable payback period, reject the project.

Net Present Value (NPV)Net Present Value (NPV)

Is the present value at net cash inflows generated by a project including salvage value, if any, less the initial investment on the project.

DECISION CRITERIADECISION CRITERIAWhen NPV is used to make accept–reject decisions, the

decision criteria are as follows:

• If the NPV is greater than $0, accept the project.

• If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.

PROFITABILITY INDEXPROFITABILITY INDEXThe profitability index (PI) is simply

equal to the present value of cash inflows divided by the initial cash outflow.

Internal Rate of return (IRR)Internal Rate of return (IRR)

The internal rate of return (IRR) is one of the most widely used capital budgeting techniques. The internal rate of return (IRR) is 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. Mathematically, the IRR is the value of r in Equation 10.1 that causes NPV to equal $0.

DECISION CRITERIADECISION CRITERIA

When IRR is used to make accept–reject decisions, the decision criteria are as follows:

• If the IRR is greater than the cost of capital, accept the project.

• If the IRR is less than the cost of capital, reject the project.

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