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Capital Budgeting (Categories (Replacement projects to maintain the…
Capital Budgeting
Categories
- Replacement projects to maintain the business are normally made without detailed analysis.
- Replacement projects for cost reduction determine whether equipment that is obsolete, but still usable, should be replaced. A fairly detailed analysis is necessary in this case.
- Expansion projects are taken on to grow the business and involve a complex decision-making process because they require an explicit forecast of future demand. A very detailed analysis is required.
- New product or market development also entails a complex decision-making process that will require a detailed analysis due to the large amount of uncertainty involved.
- Mandatory projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. These projects typically generate little to no revenue, but they accompany new revenue-producing projects undertaken by the company.
- Other projects. Some projects are not easily analyzed through the capital budgeting process. Such projects may include a pet project of senior management (e.g., corporate perks) or a high-risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g., research and development projects).
five key principles
- Decisions are based on cash flows, not accounting income. The relevant cash flows to consider as part of the capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken.
Sunk costs are costs that cannot be avoided, even if the project is not undertaken.
Externalities are the effects the acceptance of a project may have on other firm cash flows. The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product.
- Cash flows are based on opportunity costs. Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis.
- The timing of cash flows is important.
- Cash flows are analyzed on an after-tax basis.
- Financing costs are reflected in the project’s required rate of return.
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NPV & IRR
A positive NPV project is expected to increase shareholder wealth, a negative NPV project is expected to decrease shareholder wealth, and a zero NPV project has no expected effect on shareholder wealth.
For a normal project, the internal rate of return (IRR) is the discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project.
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Independent vs. Mutually Exclusive Projects #
Independent projects are projects that are unrelated to each other and allow for each project to be evaluated based on its own profitability.
Mutually exclusive means that only one project in a set of possible projects can be accepted and that the projects compete with each other.
Payback Period
The payback period (PBP) is the number of years it takes to recover the initial cost of an investment.
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Profitability Index (PI)
The profitability index (PI) is the present value of a project’s future cash flows divided by the initial cash outlay