...Capital Budgeting Processes and Techniques Keith A. Rossmiller Business 657 Instructor Maxwell September 3, 2012 Capital Budgeting 2 Capital Budget Processes and Techniques Investment decisions impact the long-term success or failure of a company. The capital budgeting theory assumes that the primary goal of a firm’s shareholders is to maximize firm value. The process of analyzing and prioritizing investment opportunities is capital budgeting. Capital budgeting involves three basic steps of identifying potential investments, analyzing the set of investment opportunities that will create shareholder value, and implementing and monitoring the investment projects that a firm should undertake. Managers need analytical tools to help them make the best investment decisions for their firm. This paper will explore six different methods of evaluating investment projects and their advantages and disadvantages. The six methods are the payback period, discounted payback period, net present value, profitability index, internal rate of return, and modified internal rate of return, which method is most used in business, and issues related to capital budgeting. Capital Budgeting 3 Payback Period The first...
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...Capital budgeting techniques: Capital budgeting techniques: In making decisions regarding investment in a certain project, a number of techniques referred to as capital budgeting techniques namely net present value (NPV), profitability index (PI), internal rate of return (IRR) and payback period are used. The net present value (NPV) is defined as the discounted present value of a project’s future cash flows. This means that for the project to be viable, the present value of invested cash should be positive that is the present value should be greater than the initial funds invested. Given that it uses discounting as a means of determining the present value, it means it takes into consideration fluctuations caused by interest rates. The main strength of this method is that it can indicate the present value of a project even when the rate of interest varies which is not possible in the case of the payback method. The method also is specific given that it gives only a single outcome and also it can be used in the case of projects that are mutually exclusive and therefore it’s easy to determine the project which will lead to greater wealth maximization as it gives this value in absolute terms. The main weakness of the NPV is that interpretation is sometimes difficult since future forecasts regarding profitability could change and hence the cash flows...
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...be taken when selecting from a range of projects is which method(s) of Capital Budgeting a company will opt for in order to arrive at the final proposed solution. “Investment decisions must be consistent with the objectives of the particular business. For a private sector business, maximising the wealth of the owners (shareholders) is usually assumed to be the key financial objective.” (Atrill and McLaney, 2009, p. 259) As a company exists primarily to increase the wealth of the stakeholders it should only invest capital to implement a project when the outcome will result in benefits that exceed the cost of the investment. Appraisals need to be carried out in order to select the project which provides the best return on that investment. Capital Budgeting is the process of appraising these projects in order to select the project most suited to the company‟s strategy. The purpose of this report is to discuss four methods of appraisal (Payback Period, Accounting Rate of Return, Net Present Value and Internal Rate of Return). A case study describes each of these appraisal processes when applied to the requirement to purchase one printing press, to be selected from two qualifying contenders. This is achieved through an in-depth appraisal analysis coupled with a review of sensitivity analysis, in turn followed by an assessment of installation risks that could adversely affect the appraisal process. “Budgeting and cost management is the estimating of costs and the setting of an agreed...
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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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...Individual Project/DB Capital Budgeting Janella Chapman ACCT-614/Applied Managerial Accounting March 15, 2013 Professor Tracie Edmond I. Overview As companies look to grow and expand operations, product lines, or locations, capital budgeting is the method used by management in evaluating if projects and long-term investments will be profitable for the company. Capital budgeting analysis evaluates projects that will have cash flows for longer than a year. Capital budgeting helps management analysis if investments will be profitable and valuable to the company compared to the initial investment needed and the risk associated with the investment. There are many capital budgeting methods management may use to ensure the project or investment is aligned with the corporate strategy of a company. In the capital budgeting process, management evaluates different capital budgeting techniques to ensure the company has the resources to invest in the project, and also helps management determine if the investment will help achieve the goals and objectives of the company. The goal of capital budgeting is to evaluate the costs of an investment to the initial capital to determine if the investment will generate more capital or cash flow for the company. The four capital budgeting techniques used by management are Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and Payback method. SAC has developed new manufacturing techniques to offer special spark...
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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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...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. Net Present Value (NPV) The Net Present Value evaluates the investments by analyzing cash flows. The first concept of NPV is to determine the amount of cash that will flow in due to undertaking...
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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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...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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...also succeed within their market, and the second has to do with changes in the local economy. In an effort to determine an appropriate response to these changes, Mr. Navallez and his team has begun analyzing these changes that are affecting his business. Mr. Navallez does have a few ideas on how to move forward but will have to research more on the correct capital budgeting that is best for his organization. Capital budgeting is defined as the process of choosing the organizations long term capital investment strategy, this often consist of things like land, property and equipment (Emery, Finnerty, & Stowe, 2007). Alternatives With the changes the Mr. Navallez and his team are tasked to deal with there are some alternatives that they must decide on to adjust to the new market. They must first decide if they are going to maintain their same type of operation without changing to the industry, become an agent for the new company, or cross their organization over to becoming high tech like the new competition. Capital budgeting will be applied to the options discussed to choose the best one. Through capital budgeting the risk associated with each alternative will also be...
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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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...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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...Store Analysis FIN571 October 22,2012 Portia Boyd Abstract This paper will define and discuss the different alternatives available to Guillermo Furniture Store. I will include a sensitive analysis; the optimal weighted averages cost of capital, discuss the use of multiple valuation techniques in reducing risks and calculate the net present value of future cash flows for each of the alternatives. Guillermo Navallez was owner of Guillermo Furniture Store located in Sonora Mexico. Guillermo Furniture Store has been manufacturing handcrafted tables and chairs for a number of years. The company was operating at a profit due to inexpensive labor costs and “the area had a good supply of timber” (University of Phoenix, 2012, para. 1) to produce the handcrafted furniture. The company was prospering without any worries. In 1990, the market shifted and Guillermo began facing challenges in the businessdue to two main factors. One was an overseas furniture business moving into the area. This ompeting company uses high tech methods to produce their furniture to “exact specification” (University of Phoenix, 2012 para 2) at reasonable prices. This was unlike Guillermo’s prices which are a little higher due to their handcrafted technique. This meant the new company could produce furniture faster and cheaper than Guillermo’s company The second factor was the awakening of the laid back relaxed atmosphere in the Sonara community. This was due to the result of one of the largest...
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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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...Management Blekinge Institute of Technology THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION. By Alaba Femi, AWOMEWE & Oludele Olawale, OGUNDELE Supervisor: Anders Hederstierna Thesis for the Master’s degree in Business Administration Fall/Spring 2008 THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION. By Alaba Femi, AWOMEWE & Oludele Olawale, OGUNDELE A thesis submitted in partial fulfillment of the requirements for the degree of MBA (Master of Business Administration) Blekinge Institute of Technology 2008 Supervisor Anders Hederstierna ii Abstract Title: The importance of the Payback method in Capital budgeting decision. Authors: Alaba Femi, Awomewe and Oludele Olawale, Ogundele Supervisor: Anders Hederstierna Department: School of Management, Blekinge Institute of Technology Course: Master’s thesis in business administration, 15 credits (ECTS). Background and Problem Discussion: The capital budgeting decision has been a very typical issue in the sustenance of a company. Several companies have lost their identity or liquidated due to wrong capital budgeting decision they made at one particular time or the other. Based on these prevalent problems in industries and the effect of globalisation on industries, it is important to use effective method to analyse investment before decision is made. Capital budgeting is extremely important because the decision made involve the direction and opportunity...
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