...The recommendation to acquire Corporate B is due to multiple factors from analyzing the projected income statement and project cash flow statement for the next five years. The first thing reviewed was the revenue generated in comparison to the operating expenses, not including depreciation, before income taxes. Corporation A ranged from 20% to 24% over the five year projection, while Corporation B ranged from 40% to 42% over the same time period. The net income for Corporation A is consistent across the five year project and approximately 56% of revenues, indicating a large portion retained within the organization. Corporation B’s net income is approximately 40% over the same projection. If the only statement analyzed is the income statement, Corporation A would appear to be more appealing, however, it would be a mistake to only review one of financial statement and not review or calculate other important information such as statement of cash flow, net present value, profitability index, internal rate of return, and payback period on investment. The statement of cash flows is an important part of the financial statements of any company and especially to investors (Keown, Martin, & Petty, 2014). This statement will explain to investors how much actual cash or money was generated by the company (Keown et al, 2014). Corporation A generated $362,997 over the five year projection, while Corporation B generated $397,763, accounting for 9.6% more than Corporation A. ...
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...Capital Budgeting Case Study Atilano Bonilla QRB/501 October 14, 2013 Vladimir Crk Capital Budgeting Case Study The authors of this paper will analyze and interpret the answers to the Capital Budgeting Case Study presented in Week 6’s material of the Quantitative Reasoning for Business course. The paper presents the rationale behind the Net Present Value (NPV) and Internal Rate of Return (IRR) results, describes the relationship between the two and explains the reasons behind the acquisition recommendation (e) in the Microsoft Excel spreadsheet. Analyzing the Results The case study presents two corporations (A and B) with different revenue values and expenses as well as variable depreciation expenses, tax rates and discount rates. Members of the team computed both corporations’ cash flow, NPV and IRR value using a Microsoft Excel spreadsheet. The net present value (NPV) of an investment proposal is equal to the present value of its annual free cash flows less the investment’s initial outlay. Whenever the project’s NPV is greater than or equal to zero, we will accept the project; whenever the NPV is negative, we will reject the project. (Keown, 2014. p. 310) On the other hand Keown (2014) points out that “the internal rate of return is defined as the discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay.” In effect, the NPV method implicitly assumes that cash flows over...
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...Chapter 11 The Basics of Capital Budgeting Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 1 2 3 | | | | Project L -100 10 60 80 Project S -100 70 50 20 Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? ...
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...CHAPTER ONE Introduction Understanding and being able to use capital budgeting techniques and investment appraisal tools is usually a standard requirement for most business degrees. In addition learning such methods will also give one an advantage in a real business situation, in which there is the consideration of significant capital expenditure project. Capital budgeting assists management decisions making on the process of ensuring growth of the organization. The techniques are divided into two types: one, Traditional (non-discounting) that includes pay back method, accounting rate of return (ARR). Two, discounting cash flow that includes net present value (NPV), internal rate of return (IRR) Profitability Index (PI). Before an investment appraisal is conducted, there are a number of points to keep in mind. Whilst the tool presented will give an evaluation of the worth of a project, one should consider that the answer is only a guide. In short, the results of an investment appraisal should be considered in conjunction with both common sense and other qualitative factors such as a business’s overall strategy. Secondly, before an investment appraisal is conducted, one should consider whether or not the project is mutually exclusive. Where a project is mutually exclusive, then only the best project should be selected. Where on the other hand, projects are independent; one may select all projects which give the appropriate return. 1.1 Background of the study Corporate finance...
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...Corporation’s capital budgeting process and identifying some of the strengths and weaknesses that come along with it. The missions of CERs and the capital budgeting at Stryker: Stryker Corporation has had an outstanding growing background since it started. They have a benchmark of 20% growth annually, and one of the reasons the firm has been able to do this is their way of managing their capital budgeting process. Stryker used CERs (Capital Expenditure Requests) in their capital allocation process. These were basically permission forms that were submitted to be filled out by the authorities in order to get allowance to spend a certain amount of money. The mission of the CERs and the capital budgeting process at striker is to standardize and formalize the capital budgeting process. The CERs made it easier for the company to keep track of the expenditures that were made in each division. Thus, the firm was able to support cash flow targets and maintain the 20% growth of the company. The CERs have been shaped by elements of corporate finance theory. The fact that the CERs are made to have a smarter way of managing the expenditures of the company, automatically refers to the principal goal of corporate finance which is to maximize shareholder’s wealth. Since the CERs are helping to maintain the 20% growth benchmark, that means that the company is growing and consequently the value of the stock prices is increasing as well as it can be appreciated in exhibit 3 of the case. ...
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...Management J. Volume 2 No. 1 (January 1989) ,' CAPITAL BUDGETING PRACTICES OF INDIAN COMPANIES I. M. PANDEY ' Objective " The objectives of this study are: (a) to document the capital bud geting policies and practices of companies in India, a developing country, and contrast them with those of USA and UK, the developed countries, and (b) to ascertain how business executives look upon the linkage between corporate strategy and investment decision-making. Capital expenditure planning and control is a process of facilitating decisions covering expenditures on long-term assets. Since a company's survival and profitability hinges on capital expenditures, specially the major ones, the importance of the capital budgeting process cannot be over-emphasized. Sample and Methodology We have followed an intensive interview-cum-questionnaire method. Two questionnaires—one dealing with investment evaluation practice and second with other phases—were sent to companies which had agreed to participate in the study. In all, 14 companies were studied. The responding companies belonged to different businesses. In terms of size (sales and number of employees), capital intensity (net tangible fixed assets), volume of spending (capital expenditure incurred), and level of technology, they represent a variety (Table 1). The study relates to 1984. •-, Capital Expenditure: How Defined Strictly speaking, capital expenditure includes all those expenditures which are expected to produce...
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...Name: Professor’s name: Dr. Wright Course: AF 211 Accounting for Planning and Control Managers in making investment decisions are faced with the problem of limited resources. This, therefore, necessitates an understanding of the topic of capital budgeting. Capital budgeting is the process of determining and pursuing investments which cash flows are expected in the future period usually more than a year. It entails the decision on the acquisition of new assets or equipment that is to be utilized by the business to increase its future cash flows and profitability. Managers are, therefore, faced with the challenge of determining which project to invest in order to avert the adverse effect on the financial performance. In making investment decisions, various factors must be considered. Managers have to know that the success of the business entirely depends on how best the investments are analyzed before they are undertaken. First, capital budgeting requires large capital outlay (Dugdale 16). Most of the capital budgeting decisions require a large proportion of business funds. It, thus, implies that failure to make proper investment decisions will lead to losses for the organization. Secondly, investment decisions are irreversible. After deciding on what projects to invest in, managers will lack the ability to reverse their decisions, i.e., equipment once acquired cannot be easily disposed of. The managers must therefore be careful before settling on a particular investment...
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...CAPITAL BUDGETING: ADVANTAGES AND LIMITATIONS. SEPTEMBER 2012 CHAPTER ONE INTRODUCTION 1.0 Background Study Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability. In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process. Capital budgeting is a process...
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...Part A “Capital budgeting over the years has become a sophisticated process for the finance officer. The different methods available to the finance officer have increased and become more accurate and centred upon the goal of maximizing wealth. However has there been an increase in the usage of these new methods or are decision makers still using the easier methods?” Capital budgeting is a tool management use to make investment decisions. Despite the pitfalls pointed out in Yee-Ching Lilian Chan’s article “Use of capital budgeting techniques and an analytic approach to capital investment decisions in Canadian Municipal Governments”, which includes overemphasis on the quantifiable aspects of capital projects, random cut offs on the timing and the amount of cash flows, Unrealistic discount rates or IRR assumptions. Methods such as profitability index, internal rate of return, breakeven, payback period and net present value are all discounted cash flows which are commonly used in practice. In 2001 Elijelly, A & Abuldris published an article “ A survey of capital budgeting techniques in the public and private sectors of a less developed country, Sudan” They concluded that most public enterprises in less developed countries, do not apply any capital budgeting methods when making investment decisions. The payback method was the most widely used followed by the Internal rate of return in the private and public sectors that did use capital budgeting techniques. “In contrast to the...
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...Handouts for Corporate Finance 1 Capital Budgeting Introduction A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of capital budgeting relies on the work of people in the areas of industrial engineering, research and development, and management information systems (among others) for the creation of investment opportunities. As such, it is important to suggest that students keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Because a project is financially sound, it must be ethically sound, right? Well . . . the question of ethical appropriateness is less frequently discussed in the context of capital budgeting than that of financial appropriateness. Consider the following simple example: The American Association of Colleges and Universities estimates that 10 percent of all college students cheat at some time during their postsecondary education careers. You might pose the ethical question of whether it would be proper for a publishing company to offer a new book How to Cheat: A User's Guide. The company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year one and 5,000 volumes in each of the following two years. The immediate printing costs for the 20,000 volumes would be $20,000. The...
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...Capital Budgeting Case for week 6 Capital Budgeting Process: Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. In the capital budget case the team analyzed and put a 5 year income statement for corporation A and corporation B. The income statement started with the information provided by the case information for the assignment It is important for business owners to analyze projects and their costs before going through with them. In order to do this they must project the value of the project to see if it is going to bring them the profits they desire. For example, if a business owner is interested in acquiring a new company, he or she must look at different aspects of the company as it is now and project the value over several years to ensure that a profit will be made. In the case presented, two companies are being compared to see which would be the better company to acquire based on income statement and cash flow projections, Net present value (NPV), and Internal rate of return (IRR). This paper will go over the reasoning for the final decision based on the analysis of the projections as well as the importance and differences of NPV and IRR. Net Present Value (NPV) The NPV is the difference of the discounted cash inflows and the discounted cash outflows. The NPV...
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...evaluates the investments by analyzing cash flows. Internal Rate of Return uses percentage that is similar to the rate of interest in comparing potential investments with other possible or existing kind of investments. The method involves dividing the expected profits from the potential investment by the expected expenditure in order to arrive at the rate of return. Evaluating capital investments is an essential task for Johnson Controls Inc. in order to understand the viability of its capital budget before venturing into the emerging markets. Evaluating investments helps the company determine if the investments in question are worthwhile. Johnson Controls Inc. may have many investment opportunities in the emerging market but it must measures the potential of each opportunity preferably in isolation and make comparison of each in order to select the a few or just one that maximizes the value of the firm and reduce the potential risk. For example, Johnson Controls Inc. might be trying to determine if venturing into the emerging market will require buying new equipment or using the existing ones. The company might also be interested in determining if there is need to invest in research and development before venturing into the emerging market with a new or existing product. The company can therefore supplement its traditional methods of evaluating investments (such as payback period) with Net Present Value (NPV) and Internal Rate of Return (IRR) as well as Multiple Techniques. ...
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...Risk Management in Capital Budgeting Process Introduction: Capital investment decision, like the capital budgeting process, includes series of analysis and decision making processes that have long term impact on the company. Any investment conducted for future net cash growth by company’s management, regardless of investing in intangible or tangible assets can be described as capital budgeting. Company management has obligations towards company owners to increase company wealth. Risk has been recognized as an important component in the capital budget decision making. The future is uncertain and investments techniques that fail to recognize this fact will almost certainly lead to incorrect conclusions and erroneous recommendations. In today’s uncertain and unpredictable global market, where technical, technological and economic development speed is rapidly increasing, selection of optimal process and selection of optimal project is significantly difficult. In many respects, capital budgeting defines an organization’s leadership. Capital budgeting decisions establish strategic priorities, allocate managers to assemble and communicate information across traditional organizational boundaries, for example, marketing, engineering, production, and accounting. The information is evaluated within a rational cost/benefit decision framework by analyzing cash inflows and outflows over time. In project selection process, corporate manager uses various criteria and methods in selecting...
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...Capital Budgeting Introduction A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of capital budgeting relies on the work of people in the areas of industrial engineering, research and development, and management information systems (among others) for the creation of investment opportunities. As such, it is important to suggest that students keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Because a project is financially sound, it must be ethically sound, right? Well . . . the question of ethical appropriateness is less frequently discussed in the context of capital budgeting than that of financial appropriateness. Consider the following simple example: The American Association of Colleges and Universities estimates that 10 percent of all college students cheat at some time during their postsecondary education careers. You might pose the ethical question of whether it would be proper for a publishing company to offer a new book How to Cheat: A User's Guide. The company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year one and 5,000 volumes in each of the following two years. The immediate printing costs for the 20,000 volumes would be $20,000. The book would sell for $7.50 per copy and...
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...shorter life favoured at the expense of longer life projects, which are more illiquid. Under UWA Plastic criterion the project must recover the initial investment within six years. The ITF project has a payback period of 3.6 years meaning the project would be accepted. However, the payback method may not provide a reliable decision as it ignores the time value of money and also ignores all cash flows that occur after the payback period relies on an ad hoc decision. Therefore, with respect to the three other criteria’s the payback period, should hold the smallest weight when deciding whether to invest in the ITF project. This is exemplified by the decline in the number of CFO’s using the payback method as their primary method of capital budgeting. The DCF uses the incremental earnings of the project to forecast the cash flows of the project. In doing so...
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