fin 501 capital budgeting

7/21/2019 Fin 501 Capital Budgeting

1/14

apital Budgeting

apital Budgeting


2/14

Capital Budgeting is the processCapital Budgeting is the process

of evaluating and selecting long-of evaluating and selecting long-

term investments that areterm investments that are

consistent with the firms goal ofconsistent with the firms goal of

maximizing owners wealth.maximizing owners wealth.

Capital Budgeting


3/14

Motives For Capital ExpenditureMotives For Capital Expenditure

Capital ExpenditureCapital Expenditure: An outlay of: An outlay offunds by the firm that is expected tofunds by the firm that is expected to

produce benefits over a period of timeproduce benefits over a period of timegreater than one year.greater than one year.

Operating ExpenditureOperating Expenditure: An outlay of: An outlay offunds by the firm resulting in benefitsfunds by the firm resulting in benefitsreceived within one year.received within one year.


4/14

Motives For apital

otives For apital

Expenditurexpenditure

Companies mae capital expenditures forCompanies mae capital expenditures for

many reasons. !he basic motives formany reasons. !he basic motives for

capital expenditures arecapital expenditures are to expand operations"to expand operations"

to replace or renew fixed assets"to replace or renew fixed assets"

to obtain some other" less tangible benefitto obtain some other" less tangible benefitover a long period.over a long period.


5/14

Capital budgeting processCapital budgeting process: #ive: #ivedistinct but interrelated steps: proposaldistinct but interrelated steps: proposal

generation" review and analysis" decisiongeneration" review and analysis" decisionmaing" implementation" and follow-up.maing" implementation" and follow-up.

Steps in processSteps in process::

$.%roposal generation$.%roposal generation

&.'eview and analysis&.'eview and analysis

(.)ecision maing(.)ecision maing*.implementation*.implementation

+.#ollow-up+.#ollow-up


6/14

Basic Terminology

asic Terminology

Independent versus mutually Exclusive ProjectsIndependent versus mutually Exclusive Projects

, Independent projectsIndependent projects: %roects whose cash: %roects whose cash

flows are unrelated to one another theflows are unrelated to one another the

acceptance of one does not eliminate the othersacceptance of one does not eliminate the others

from further consideration.from further consideration.

, Mutually exclusive projectsMutually exclusive projects: %roects that: %roects thatcompete with one another" so that the acceptancecompete with one another" so that the acceptance

of one eliminates from further consideration allof one eliminates from further consideration all

other proects that serve a similar function.other proects that serve a similar function.


7/14

Unlimited funds versus

nlimited funds versus

capital rationingapital rationing

/nlimited funds/nlimited funds: !he financial situation in: !he financial situation inwhich a firm is able to accept allwhich a firm is able to accept all

independent proects that provide anindependent proects that provide anacceptable return.acceptable return.

, Capital rationingCapital rationing: !he financial situation: !he financial situation

in which a firm has only a fixed number ofin which a firm has only a fixed number ofdollars available for capital expenditures"dollars available for capital expenditures"

compete for these dollars.compete for these dollars.


8/14

Accept-reject versus

ccept-reject versus

ranking Approacesanking Approaces

Accept-reject approachAccept-reject approach: !he: !heevaluation of capital expenditureevaluation of capital expenditure

proposals to determine whether they meetproposals to determine whether they meet

the firms minimum acceptance criterion.the firms minimum acceptance criterion.

an!ing Approachan!ing Approach: !he raning of: !he raning ofcapital expenditure proects on the basiscapital expenditure proects on the basis

of some predetermined measure" such asof some predetermined measure" such as

the rate of return.the rate of return.


9/14

apital Budgeting

apital Budgeting

Tecni!ues

ecni!ues

Paybac! periodPaybac! period::

!he amount of time re0uired for a firm!he amount of time re0uired for a firm

to recover its initial investment in a proect"to recover its initial investment in a proect"as calculated from cash inflows.as calculated from cash inflows.


10/14

"ros and ons of pay#ack

ros and ons of pay#ack

period

eriod

1erits1erits2asy to evaluate small proect2asy to evaluate small proect

3imple to compute3imple to compute

4ives implicit consideration to the timing4ives implicit consideration to the timing

of cash flowof cash flow

Can be viewed as a measure of risCan be viewed as a measure of ris

exposureexposure


11/14

, )emerits)emerits)o not consider the time value of money.)o not consider the time value of money.

Cannot be specified in light of the wealthCannot be specified in light of the wealth

maximization goal.maximization goal.


12/14

$elevant as

elevant as

Flo%s

lo%s

and pay#ack

and pay#ack

periods for &Eyaman Enterprises'

eriods for &Eyaman Enterprises'

projects

rojects

%roect gold %roect silver%roect gold %roect silver

5nitial 5nvestment 66 +7777 66 +7777

8ear 9perating cash inflows8ear 9perating cash inflows $ 6+777 6*7777$ 6+777 6*7777

& +777 &777& +777 &777

( *7777 777( *7777 777

* $7777 $7777* $7777 $7777

+ $7777 $7777+ $7777 $7777

%aybac period ( years ( years%aybac period ( years ( years


13/14

(et "resent )alue *(")+(et "resent )alue *(")+ A sophisticated capital budgetingA sophisticated capital budgeting

techni0ue founded by subtracting atechni0ue founded by subtracting a

proects initial investment from theproects initial investment from thepresent value of its cash inflowspresent value of its cash inflows

discounted at a rate e0ual to the firmsdiscounted at a rate e0ual to the firms

cost of capital.cost of capital.


14/14

,

(") and te "rofita#ility(") and te "rofita#ility

indexindex Internal rate o" return #I$%Internal rate o" return #I$%

!he discount rate that e0uates the ;%< of!he discount rate that e0uates the ;%< of

an investment opportunity withan investment opportunity with67=because the present value of cash67=because the present value of cash

inflows e0uals the initial investment> it isinflows e0uals the initial investment> it is

the rate of return that the firm will earn ifthe rate of return that the firm will earn ifit invests in the proect and receives theit invests in the proect and receives the

given cash inflows.given cash inflows.

fin 501 capital budgeting

Documents