Identify potential investments 2. Evaluate the set of opportunities, choosing those that create shareholder value, prioritize 3. Implement and monitor the investment projects selected The capital budgeting process begins with an idea and ends with implementation and monitoring. In this particular problem we are focusing on the second step in the process: analyzing the merits of the investment proposal to expand and simultaneously replace old equipment. There are analytical tools that weigh the merits of investment projects on several dimensions.
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To decide which investments to undertake, managers need an analytical tool that: (1) is easy to apply and explain to nonfinancial personnel; (2) focuses on cash flow, not accounting measures; (3) accounts for time-value of money; (4) adjusts for differences in risk across projects; and (5) leads to higher firm value in any company (Graham, Smart, Megginson, 2010). All things being equal, managers would prefer an easily applied capital budgeting technique that considers cash flow, recognizes the time value of money, fully accounts for expected risk and return, and ultimately leads to higher stock values.
Glossary of Capital Budgeting Terms and Concepts: Capital budgeting techniques include the payback period, discounted payback period, which are less sophisticated techniques because they do not deal with the time value of money and are not tied to the organization’s goal of maximizing shareholder wealth. Techniques that are more sophisticated include net present value (NPV), internal rate of return (IRR), and profitability index (PI). Payback period – Is the amount of time it takes for a given project’s cumulative net cash inflows to recoup the initial investment.
Firms using this method define a maximum amount of 3 time acceptable for the payback period and then accept only those projects that can have payback periods less than this maximum time. Discounted payback period – In calculating the payback period, manager’s first discount the cash flows. The method calculates how long it takes for a project’s discounted cash flows to recover the initial outlay. Net present value (NPV) – A projects NPV equals the sum of its cash inflows and outflows, discounted at a rate that is consistent with the projects risk.
NPV=0 – This is because the investment’s cash flows precisely satisfy the investor’s expectation of the percentage of return. Economic value added (EVA) – This metric subtracts “normal profit” from an investment’s cash flow to determine whether the investment is adding value for shareholders. NPV profile – Illustrates the relationship between a typical project’s NPV and its IRR in context of the firm’s discount rate. Internal rate of return (IRR) – The IRR of an investment project is the compound annual rate of return on the project, given its up-front costs and subsequent cash flows.
A project’s IRR is the discount rate that causes the net present value of all project cash flows to equal zero. Accept the project if the IRR exceeds the firm’s hurdle rate. Multiple IRR’s – This happens when a project’s cash flows alternate between negative and positive values. Mutually exclusive projects – When two project’s offer IRR’s in excess of the hurdle rate, but the firm can invest in only one, the answer is not always the obvious one, the one with the highest IRR. Profitability index (PI) – Compute the present value of a firm’s cash inflows for the years of the project and then divide by the initial cash outflow to obtain the PI.
Accept the project if the PI exceeds one (1). Cash flow analysis helps us determine just what a project’s relevant cash flows will be – that is, the inputs for the capital budgeting decision tools, focusing on which cash flows one should include when calculating a project’s NPV. A capital budgeting problem will have time zero initial investment cash flows, operating life cash flows, and terminal period end of project cash flows, because we are interested in the cash flow consequences of investments we must understand which cash flows to include. Initial cash outflow for a project – The acquisition of a fixed asset and it’s tax credit, the after taxes salvage value of a fixed asset if it applies, and the net working capital we add. Sunk costs – Costs that have been incurred in the past and cannot be recovered, these are costs that have already been spent and are not recoverable. Opportunity costs – of one investment are the cash flows on the alternative investment that the firm decides not to make.
Operating life cash flows – Over the years of the project the earnings before taxes, EBIT less taxes which equals net income, and then add the depreciation back in to get operating cash flows. Terminal period end of project cash flows – to calculate terminal value, take the final year of cash flow projections and make an assumption that all future cash flows from the project will grow at a constant rate. Incremental cash flows – only those cash flows that are incremental to the project.