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Chapter 11: Capital Budgeting, HANIS NURARISYA BINTI ABDUL MANAP |…
Chapter 11:
Capital Budgeting
What is capital budgeting :question:
Decision making process of selecting and evaluating long term investments.
Types of project :fountain_pen:
:one: Independent projects
Projects with cash flow, which are unrelated with other.
Decision to accept one project, will not effect other project.
:two: Mutually exclusive projects
The decision is made to choose only one project.
Decision to accept one project, automatically rejection of other.
Types of capital investment :pencil2:
:one: For expenditure
Occurs when the company wants to intro a new product, to penetrate into new market and to open up new branch.
:two: For replacement of existing assets.
Replacing an existing asset with a new asset.
:three: Safety and environmental project.
Importance of capital budgeting :star:
To stay in the industry / to be a leader market.
Right decision is needed with respects to the investments in fixed assets.
Right decision :check: : Firm's value :arrow_up: , shareholders' wealth :arrow_up:
Wrong decision :green_cross: : Hard for firms to reverse the situation.
Initial Outlay :question:
Called as initial investment.
Refers to the immediate cash outflows required by a firm to start a project.
Capital budgeting techniques :fire:
:black_small_square: Non-discounted cash flow methods.
Payback period.
Measures how quickly the firm can recover its initial outlay.
Number of years needed for a projects to return its initial investments.
Earlier, the better.
Decision Criteria:
:star: Independent project
Accept - If its payback period is < / = to the firm's maximum desired payback period.
Mutually Projects :star:
Accept the projects with the shortest payback period.
Advantages :check:
Easy to calculate.
Liquidity indicator.
Risk indicator.
Disadvantages :green_cross:
Ignore time value of money.
Ignores cash flows occurring after payback period.
Bad profitability indicator.
Biased against the long term project.
:black_small_square: Discounted cash flow methods.
Not present value (NPV)
Internal rate of return (IRR)
NPV-Using PVIF Table
Decision criteria:
:star: Independent project
Accept - both projects if NPV > 0 (+ve)
Mutually Projects :star:
Accept the project with the highest NPV
Advantages :check:
It uses cash flows.
It recognizes time value of money.
It is consistence with the firm's goal of shareholder's wealth maximization.
Disadvantages :green_cross:
Requires detailed long term forecast of incremental benefits and costs
IRR
Will determine the return that will make the NPV = 0 / > 0 (+ve)
IRR uneven cash flow:
More complexes
Use try and error method.
Decision criteria:
:star: Independent projects
Accept - both projects if IRR for both projects > required rate of return.
Mutually projects :star:
Accept the projects with the highest IRR.
Advantages :check:
It uses cash flow
It recognizes time value of money.
Disadvantages :green_cross:
Requires detailed long term forecast of incremental benefits and costs.
:black_small_square: Profitability Index (PI)
Present value of cash flows earned per Ringgit of initial cash invested [ Present value of cash flows / initial investment (outlay) ]
Decision criteria:
:star: Independent projects
Accept - both projects if PI for both projects > tan 1.
Mutually projects :star:
Accept the projects with the PI > 1
HANIS NURARISYA BINTI ABDUL MANAP | 2019219288 | KBA2462A
