Capital Budgeting Essay

3031 words - 13 pages

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

I. CAPITAL IS A LIMITED RESOURCE

In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. ...view middle of the document...

Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital.

Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.

II. Basic Steps of Capital Budgeting

1. Estimate the cash flows

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or
payback < policy

Definitions:
Independent versus mutually exclusive projects.
Normal versus nonnormal projects.

Basic Data

| |Expected Net Cash Flow |
|Year |Project L |Project S |
|0 | ($100) | ($100) |
|1 |10 |70 |
|2 |60 |50 |
|3 |80 |20 |

III. Evaluation Techniques

A. Payback period

B. Net present value (NPV)
C. Internal rate of return (IRR)
D. Modified internal rate of return (MIRR)
E. Profitability index

A. PAYBACK PERIOD
Payback period = Expected number of years required to recover a project’s cost.

| |Project L |
| |Expected Net Cash Flow |
|Year |Project L |Project S |
|0 | ($100) | ($100) |
|1 |10 |(90) |
|2 |60 |(30) |
|3 |80 |50 |

PaybackL = 2 + $30/$80 years
= 2.4 years.
PaybackS = 1.6 years.

Weaknesses of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback method.

2. Ignores cash flows occurring after the payback period.

B. NET PRESENT VALUE

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Project L:

...

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