CAPITAL BUDGETING
BRIEF CONCEPT
Capital budgeting is the process of evaluation and selecting long-term investments that a consistent with the firm’s goal of maximing owner wealth.
Key motives for Making Capital Expenditures
Motive | Description |
Expansion | Usually through acquisition of fixed assets |
Replacement or renewal | The firm will made to increase efficiency by replacing or renewing obsolute or worn-out assets. |
Other purposes | The firm involve a long term commitment of funds in expectation of a future return. These expenditures include outlays for advertising campaigns, research and development, management consulting, and new products. |
Basic terminology
Type of project :
· Mutually exclusive, are investment that a firm can select one or another but no both.
· Independent, are investment that a firm can select one, or the other, or both – as long as they meet minimum profitability thresholds. The acceptance of one doesn’t eliminate the other from further consideration.
The availability of funds for capital expenditure :
· Unlimited funds, the financial situation in which a firm is able to accept all independents project that provide an acceptable return.
· Capital rationing, restrictios since they only have a given amount of funds to invest in potential investment projects at any given time.
Decision Practices Approaches :
· Accept/Reject, the evaluation of capital expenditure proposals to determine whether the meet the firm’s minimum acceptabce criterion.
· Ranking, the ranking of capital expenditure projects on the basis of some predetermined measure such as rate of return.
Capital Budgeting Cash Flows
Relevant cash flows : Expansion versus Replacement Cash Flows.
a. Initial Investment
The Basic Format for Determining Initial Investment
Installed cost of proposed asset =
Cost of proposed asset
+ Installation costs
Total installed cost-proposed
-After tax proceed from sale of old asset =
Proceed from sale of old asset
±Tax on sale of old asset
Total after tax proceed-old
±Change in net working capital
Initial investment
Notes :
±Tax on sale of old asset è (Proceeds from sale of old asset – Book Value) x %tax
Book Value = installed cost of asset – accumulated depreciation
±Change in net working capital è current asset – current liabilities
Basic Tax Rules :
Tax Treatment on Sales of Asset
Form taxable income | Definition | Tax Treatment | Assumed tax rate |
Gain on sale of asset | Portion of the sale price that is greater than book value. | All gains above book value are taxed as ordinary income. | 40% |
Loss on sale of asset | Amount by which sale price is less than book value | If the asset is depreciable and used savings in business, loss is deducted from ordinary income. | 40% of loss is a tax savings. |
If the asset is not 40% of loss is a tax depreciable or is not savings used in business, loss is deductable only against capital gains. |
- Operating Cash Inflows
Calculation of Operating Cash Inflows Using the Income Statement format
Revenue |
- Expenses(excluding depreciation & interest) |
EBDIT |
- Depreciation |
EBIT |
- Taxes (rate=T) |
NOPAT |
+ Depreciation |
Operating cash inflows (same as OCF) |
a. Terminal Cash Flow
The Basic Format for Determining Terminal Cash Flow After tax proceed from sale of proposed asset =
Procceeds from sale of proposed asset
±Tax on sale of proposed asset
Total after tax proceeds-proposed
-After tax proceed from sale of old machine =
Proceeds from sale of old machine
±Tax on sale of old machine
Total after tax proceeds-old
±Change in net working capital
Terminal Cash flow
Capital Budgeting Techniques
Risk & Refinements in Capital Budgeting
Scenario analysis is a behavioral approach similar to sensitivity analysis but is broader in scope.
This method evaluates the impact on the firm’s return of simultaneous changes in a number of variables, such as cash inflows, outflows, and the cost of capital. NPV is then calculated under each different set of variable assumptions.
Simulation is a statistically-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.
Risk-Adjusted Discount Rates
Risk-adjusted discount rates are rates of return that must be earned on given projects to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price. The higher the risk of a project, the higher the RADR—and thus the lower a project’s NPV.
Using CAPM to find RADR
Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
Comparing Projects With Unequal Lives
If projects are independent, comparing projects with unequal lives is not critical. But when unequal-lived projects are mutually exclusive, the impact of differing lives must be considered because they do not provide service over comparable time periods. This is particularly important when continuing service is needed from the projects under consideration.
Annualized NPV (ANPV)
ANPV is an approach to evaluating un-equal lived projects that converts the net present value of unequal lived, mutually exclusive projects into an equivalent annual amount (in NPV terms)
Capital Rationing
Firm’s often operate under conditions of capital rationing—they have more acceptable independent projects than they can fund.
In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs.
However, research has found that management internally imposes capital expenditure constraints to avoid what it deems to be “excessive” levels of new financing, particularly debt. Thus, the objective of capital rationing is to select the group of projects within the firm’s budget that provides the highest overall NPV or IRR.
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