...TYPES OF CAPITAL INVESTMENT DECISION Keputusan investasi modal (capital investment decision) berkaitan dengan proses perencanaan, penetapan tujuan dan prioritas, pegaturan pendanaan, serta penggunaan kriteria tertentu untuk memilih aktiva jangka panjang. Karena keputusan investasi modal menempatkan sejumlah besar sumber daya pada resiko jangka panjang dan mempengaruhi perkembangan perusahaan secara simultan di masa depan, hal itu merupakan salah satu keputusan terpenting yang dibuat manajer. Proses pengambilan keputusan investasi modal sering disebut penganggaran modal (capital budgeting). Ada dua jenis proyek penganggaran modal : proyek independen dan proyek saling eksklusif. Proyek independen (independent project) adalah proyek yang jika diterima atau ditolak, tidak akan mempengaruhi arus kas proyek lainnya. Sedangkan, proyek saling eksklusif (mutually exclusive project) adalah proyek – proyek yang apabila diterima akan menghalangi penerimaan proyek lain. Keputusan investasi modal sering berkaitan dengan masalah investasi dalam aktiva modal jangka panjang. Kecuali tanah, aktiva selalu disusurkan selama umur manfaatnya dan investasi dipakai ketika aktiva itu digunakan. Investasi modal yang baik umumnya akan menerima kembali modal awal sepanjang umurnya dan menghasilkan pengembalian yang cukup atas investasi awal pada saat yang sama. Jadi, salah satu tugas manajer adalah memutuskan apakah suatu investasi modal akan menghasilkan kembali sumber daya awalnya atau tidak dan...
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...Corporate Finance II Lecture 04 Shama-e Zaheer Risk and Return Risk is the variability of returns from any asset. The greater the risk, the greater the required return from the asset. Therefore, in order to find the required return from any asset we need to know its risk and match that risk to another asset (or portfolio of assets) with a known return and use that as the opportunity cost of capital for the risky asset. Required Return, or, ri = Risk-free Rate (RFR) + Risk Premium (RP) Measuring Risk Calculate the standard deviation of returns to measure the variability, hence the risk of an asset. Possible Return Probability of Occurrence (Project A) Probability of Occurrence (Project B) -0.1 0.05 0.01 -0.02 0.1 0.03 0.04 0.2 0.16 0.09 0.3 0.6 0.14 0.2 0.16 0.2 0.1 0.03 0.28 0.05 0.01 Returns could also take continuous values, in which case, a normal distribution of returns may be assumed and probabilities associated with range of values may be calculated. To compare the riskiness of alternatives of different expected returns, use Coefficient of Variation instead of standard deviation. Inv A Inv B Expected Return, R 0.08 0.24 Standard Deviation, σ 0.06 0.08 Coefficient of Variation, σ/R 0.75 0.33 Investors are generally risk-averse. Therefore, they would need to be compensated for risk through risk premia. But remember that diversification reduces risk. Therefore, investors have to be compensated for the risk they cannot diversify...
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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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...manager is to decide which, if any, projects or investments opportunities the organization should undertake. The task of analyzing and comparing financials is a daunting task, but when utilizing the tools of capital budgeting, the process of this type of business decision making can be quite useful. This paper will define capital budgeting and discuss some of the components of this decision making tool. It will also discuss some of the concerns that go along with Capital Budgeting. The Basics of Capital Budgeting What is Capital Budgeting? Organizations looking to expand their business through asset acquisition create a capital budget (Paden, n.d.). Capital budgets exclusively are associated with real estate, equipment and other potential assets used to evaluate asset impact and the potential benefit to the organization. Capital Budgeting is the process in which a business determines whether a project or investment venture are worth pursuing. It is the process of analyzing investment opportunities and deciding which one to accept (Berk & DeMarzo, 2014). Potential ventures are evaluated and the potential expenditures or investments are ranked. Usually, these types of business decisions are for large purchases or investments. Steps of Capital Budgeting There are seven steps involved in capital budgeting (Hofstrand, 2013). They are: 1. Identify long-term goals of the organization 2. Identify potential investment prospects for meeting long-term goals identified...
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...CAPITAL INVESTMENTS: MODELS USED IN DECISION MAKING Capital investments are long-term investments made by companies to eventually enhance profitability and shareholder value. Capital investments normally last a company for a number of years, and they take longer periods of time to implement or enhance within an organization. Some examples of capital investments include, but are not limited too: automation in factories (equipment and software), research and development, equipment to improve quality control, software to test productivity measures, etc. These investments include a great deal of labor, capital and time to implement. Since capital investments can be risky, meaning any losses will be large to the organization considering the amount of time and capital involved, organizations have a process to determine what capital investments they should get involved in, and why. Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing and using certain criteria to select long-term assets. (“Hansen & Mowen,” 2011) Companies may start by listing all the improvements that are to be made to affect profitability in the long run. Since these improvements will consume large amounts of time and capital, it is not feasible for companies to make multiple investments at a time. To assist in deciding which investment to take on first, the company must calculate which will be the most profitable and increase shareholder...
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...Capital Budgeting Firms continually invest funds in assets and these assets produce income and cash flows that the firms can then either reinvest in more assets or pay to its owners. These assets represent the firm's capital. Capital is the firm's total assets and is comprised of all tangible and intangible assets. These assets include physical assets (such as land, buildings, equipment, and machinery), as well as assets that represent property rights (such as accounts receivable, notes, stocks, and bonds). When we refer to capital investment, we are referring to the firm's investment in its assets. The term "capital" also has come to mean the funds used to finance the firm's assets. In this sense, capital consists of notes, bonds, stock, and short-term financing. We use the term "capital structure" to refer to the mix of these different sources of capital used to finance a firm's assets. The term "capital" in financial management, a firm's resources and the funds committed to these resources, does not mean the same thing in other fields. In accounting, the term "capital" means the owners' equity, the difference between the amount of a firm's assets and its liabilities. In economics, the term "capital" means the physical (real) of the firm, and therefore excludes the assets that represent property rights. In law the term "capital" refers to the amount of owners' equity required by statute for the protection of creditors. This amounts to the "stated capital", which often is...
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...MBA7001 Accounting for Decision-Makers Week 6 Lecture – Capital Investment Appraisal Slide 10.2 Chapter 10 Making capital investment decisions LEARNING OUTCOMES CHAPTER 10: Investment Appraisal Methods You should be able to: Explain the nature and importance of investment decision making First hour – 23.11.11 Identify the four main investment appraisal methods found in practice •Payback •ARR Use each method to reach a decision on a particular investment opportunity Discuss the attributes of each of the methods 1 Atrill and McLaney, Accounting and Finance for Non-Specialists, 7th Edition, © Pearson Education Limited 2011 Investment Appraisal Investment appraisal methods used in practice Investment appraisal – the process of appraising the potential investment projects. Assessment of the level of expected returns earned for the level of expenditure made. Estimates of future costs and benefits over the project’s life. 3 • Every business would like to do everything • But it all costs • Capital expenditure on new projects or purchases (fixed assets) needs to be planned • Capital is always rationed Scenario: • Your business wishes to expand its product line • It is considering Products A and B but it can only afford to do one. • How does it decide? What main factors affect the investment decision • How much will it cost ? Investment appraisal methods used in practice • How much will I get back ? • When will I get the income ? • 4 main techniques available ranging from ...
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...information concerning capital budget recommendations for Guillermo Furniture. The firm has come to a crossroads in its industry. Due to competitive forces that have recently entered the firm’s market, the firm must decide if it should make capital investments to become a high tech manufacturer, become a distributor, or due nothing and continue its traditional course of operations. Capital investments are instrumental to future successes realizable by Guillermo and “business profitability ultimately hinges, to a large extent, on the quality of a few capital investment decisions” (Edmonds, 2007). As a result, we will explore recommendations for Guillermo to vacate its current landscape of operations for a more innovative approach as a high tech manufacturer or distributor. The goal of this brief is to convey the most appropriate management of Guillermo Furniture’s capital funds and ascertain the best return on the firm’s investments. There are various techniques available for the firm to utilize. Consequently, this memo will also serve to explain the fundamental differences between the following two techniques, net present value (NPV) and internal rate of return (IRR). Differences: NPV and IRR There are many techniques available for managers to use when analyzing potential capital investments. NPV compares the present value of an investment with the costs associated with the investment. The difference between the present value and the cost of the investment equals the net present...
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...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 projects because of this nature. Moreover, in analyzing investment, the future cash...
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...CAPITAL BUDGETING DECISION 1. Meaning Capital budgeting denotes situation where funds are invested immediately and returns are expected after a year. In growing orgnisation capital budgeting is more or less continuous process and it is carried out by top management. The role of any Finance Manager is to critically evaluate proposal, evaluation of alternative proposal and select best one. The following are the some of the cases where heavy capital investment may be necessary. A) Replacement of fixed assets: - To replace old Assets. To buy Asset with latest technology. B) Expansion: - It means increase in production capacity to meet additional demand. C) Research and Development: - It is required for those industry where technology in changing rapidly. D) Diversification: - To set up factories, to fulfill need of various markets. To reduce dependency on one market E) Miscellaneous: - To meet legal norms, such as investment in pollution control equipment. 2. Features and significance of capital budgeting Capital budgeting includes investment for long firm funds for long term and their utilisation. Capital budgeting decision affects profitability of firm. Therefore these decisions are very important. A wrong decision taken by finance manager may affect firm’s profitability. The relevance and significance of capital budgeting may be stated as follows. A) Involvement of heavy funds: - Capital budgeting decision requires large amount of capital...
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...Capital budgeting is a process that involves making of investment decision by company from one or a series of investment projects to identify the most worthwhile projects for undertaking. A company’s capital investment usually focuses:- • Expansion in existing market • Develop new products or entering new market • Purchase new building / plants • Replacement or improvement on existing equipment Capital budgeting decision is vital for any company because it always involved: • Large investment – capital budgeting decision usually involve large investment of funds but mostly there is a shortage of funds at every firm. Hence the funds and the resources need to be controlled by the firm • Irreversible nature- once the decision for acquiring a permanent assets is taken, it becomes very difficult to dispose of these assets with the incurring heavy cost • Long term effect on profitability- Not only the present earning of the firm is affected but the future growth and profitability also depend upon investment decision taken today, any unsound decision made can lead to a downfall tomorrow Capital budgeting is a complex process as it involved decision relating to the investment of current funds for the benefit to be achieved in the future but future is always uncertain. The 5 step process in capital budgeting decision is: I. Identified investment opportunities- investment proposal or projects normally was initiated by a firm’s management or staffs in line with the corporate...
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...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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...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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...Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 – Business Economics and Financial Mathematics) Y O Lam Capital budgeting assists decision makers in a company evaluate multiple investments of the company’s capital. Capital budgeting is used to plan for the acquisitions of other companies, for the development of new product lines of business, for the expansion of the existing production plants or for the replacement worn-out equipment, and in planning decisions on whether or not to enter a new market line, whether to buy or rent production facilities, and any other investment project resulting in costs and revenues that are spread over a number of years. Capital budgeting is the method used to assess a major investment or to see whether one option is better than another. There are several capital budgeting methods, each with advantages and disadvantages. In this article, we discuss the basic principle and the advantages and disadvantages of using the net present value technique and the internal rate of return technique. Net present value (NPV) method When using the net present value method of capital budgeting, one of most important factors is the estimation of net cash flows from an investment. The net cash flow is the difference between cash outflows and cash inflows over the life of the investment. First, cash flows should be calculated on an incremental basis, and include changes in operating cash flows and changes in...
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...with the core corporate finance functions in an applied setting. The participants are exposed to real world corporate finance decisions to be taken up by managers for creating value. Such an exposure is accomplished through a mix of theory and practice. The pedagogy employed reflects a judicious mix of case discussions, lectures and problem solving approach. COURSE OBJECTIVES The objective is to familiarize participants with the three major decision areas of Corporate Finance, viz. the investments, financing and earnings distribution decisions. Subsequently the participants are to be offered an integrated view of the decision areas by discussing the issues in corporate valuations and risk management. The course aims at sharpening the financial decision making skills of the participants. EXPECTED LEARNING OUTCOMES AND ASSOCIATED MEASURES At the end of the course student is expected to accomplish the following learning outcomes. Alignment of Course Learning Outcomes (CLOs) with the Programme Learning Goals & Objectives and Assessment of the learning outcomes of the course is presented below: Course Learning Outcomes Have fundamental understanding of corporate finance, and apply skills in corporate financial decision making in the three major decision areas, viz. the investments, financing and earnings distribution decisions Program Level...
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