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Basic of Capital Budgeting - Coggle Diagram
Basic of Capital Budgeting
Strategic Business Plan
replacement
needed to continue current operation
cost reduction
expansion
existing products or markets
new products or markets
safety and or environmental projects
mergers
others
NPV (Net Present Value)
the present value of the project's free cash flow discounted at the cost of capital
NPV decision process
Independent projects
= project with cash flow that are not affected by the acceptance or non acceptance of other projects
Mutually exclusive projects
= a set of projects where only one can be accepted
IRR (Internal Rate of Return) = the discount rate that forces a project's NPV to equal zero
return > cost --> additional return (bonus) ,
return < cost --> shortfall
decision rule
Independent project
IRR > WACC --> accept, IRR < WACC --> reject
Mutually exclusive
IRR > WACC --> accept, if not --> reject
Multiple internal rate of return (multiple IRR)
= situation where a project has 2 or more IRR
normal cash flow
non normal cash flow
Reinvestment rate assumption
if a firm has good access to the capital markets --> potential high IRR --> project cash flow could be reinvested at a rate close to IRR
if true investment < IRR --> true rate of return on the investment < IRR --> IRR is misleading as a measure of projects profitability
Modified internal rate of return (MIRR)
= the discount rate at which the PV of project cost is equal to PV terminal value. terminal value = the sum of FV on the cash inflows, compounded at the firm's cost of capital
MIRR is better than IRR
INdependent project
for NPV, IRR, and MIRR reach the same accept/ reject conclusion (good evaluation)
Mutually exclusive project
NPV is the best because it selects the project that maximizes value
NPV profiles = relationship between a project's NPV and the firm's cost of capital
Crossover rate = the cost of capital at which the NPV profiles of 2 projects cross, and that at which the project's NPVs are equal
Payback period = the length of time required for an investment's cash flow to cover its cost
3 flaws ;
all dollars received in different years are given the same weight, cash flow beyond the payback year are given no consideration, payback tell about when will recover our investment
discounted payback = the length of time required for an investment's cash flow, discounted at the investment's cost of capital, to cover its cost
conclusion of capital budgeting methods
NPV is the single best criterion cause it provides direct measure of value the project adds to shareholder wealth
IRR and MIRR
measure profitability expressed as percentage rate of return,
contain information "safety margin",3. MIRR is better than IRR for knowing project's rate of return
payback & discounted payback indicate project's liability & risk