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CHAPTER 11: CAPITAL BUDGETING - Coggle Diagram
CHAPTER 11: CAPITAL BUDGETING
decision making process of selecting and
evaluating long term investments.
Requires a firm to make decisions with respect to investment in fixed assets investments.
Initial outlay : Refers to the immediate cash outflows required by a firm to a start a project
Types of capital investment
For expansion - occurs when the company wants to introduce a new product, to penetrate into new market, to open up new branch or increase production capacity by buying more machines.
For replacement - a company is replacing an existing asset with a new asset, old machine will be disposed off.
Safety and environmental project
Types of project :
independent projects
(Projects with cash flows, which are independent or unrelated to one another)
mutually exclusive projects
(Projects where decision is made to choose only one project from the many being considered)
Payback period
Measures how quickly the firm can recover its
initial outlay.
It is the number of years needed for a projects
to return its initial investment.
The earlier the better.
Decision criteria :
independent project :Accept – if its payback period is less than or equal to the firm’s maximum desired payback period.
mutually projects : Accept the projects with the shortest payback period
NPV - Using formula
Accept the projects with the shortest payback
period.
Alternatively it can be rephrased
NPV = CF1 + CF2 + CF3 +….+ CFn - Initial Outlay
(1+i)1 (1+i)2 (1+i)3 (1+i)n
NPV - Using PVIF Table
NPV = ∑ CF(PVIF i,n) - Initial Outlay
Decision Criteria : - independent project - Accept - both projects if NPV ≥ 0 (positive) - mutually projects - accept the projects with the highest NPV.
IRR
Tries to determine the yield or the rate of return of an investment/project.
tries to calculate the rate of return that equates the initial outlay of a project with the present value of the future net cash inflows.
In other words, will determine the return that
will make the NPV = 0 or > 0(positive)
IRR Uneven cash flow
More complexes and a tedious process
Use trial and error method
Decision criteria : - independent project - accept - both project if IRR for both projects > than required rate of return (cost of capital) - mutually project - accept the projects with the highest IRR
Profitability Index (PI)
it is relative measure that shows the present value of cash flows earned per Ringgit of initial cash invested.
= Present Value of Cash Flows
Initial Investment (Outlay)
Decision criteria :
independent project - Accept – both project if PI for both projects > than 1
mutually projects - Accept the projects with the PI > 1