Capital budgeting is fundamental to the FM decision-making process; focused on investment in fixed assets. It involves measuring the incremental cash flows associated with investment proposals and the evaluation of the attractiveness of such cash flows relative to the project’s costs. At issue is the estimation of those cash flows based on various decision criteria and how to adjust for riskiness of a given project or combination of projects. Incremental after-tax cash flows are initial outlay, differential cash flows over the projects life, and terminal cash flows. Relevant information needed for an adequate project assessment from a cash flow perspective are: Initial: Purchase price; installation fees; training; inventory and related start-up costs Differential annual cash flows: Changes in earnings (before interest and taxes); tax impact; impact on depreciation; change in net working capital; and change in capital spending. Terminal cash flow: free cash flow (over project’s life) and recapture of inventory investment (working capital) In order to make sense of the derived numbers, those beyond present day must be converted to present value to have a basis for comparison to other projects over shorter or longer periods of investment. Methods for evaluating projects:
Payback: number of years required to recover initial investment. Adds cash flows up until they equal initial fixed investment. Ignores cash flows that occur after payback period and does not consider time value of money. Present-value (PV): Net present value of an investment is the PV of the cash in flows less the PV of the cash outflows. Profitability Index: ratio of the PV of the expected future net cash flows to the initial cash outlay. IRR: discount rate that equates the PV of the project’s future net cash flows with project’s initial outlay.
Expected Return: the expectation with an investment is it will return increased value to the firm, in the form of cash flow. Management is interested in measuring the prospect of realizing a positive return to assist with investment alternative decision-making. Essentially this boils down to identification of probable outcomes, then determining the likelihood (probability) of occurrence and potential downsides—risk analysis. Many view the management effort as focused on a target or required rate of return. This equates more with a go or no go situation, wherein measurements purpose is to assist in the determination which side of the coin pertains to the immediate investment. Regarding capital budgeting decisions, management decision-making is similarly focused; finding an investment that will provide the required rate of return. These values, at least the PV, are presented in the texts appendices.
Capital budgeting involves the decision-making process with respect to investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project’s costs. Key question: what criteria should we use in the evaluation of alternative investment proposals? Use cash flows rather than accounting profits – can correctly analyze the time element of the flows. Exam flows on an after-tax basis because they are the flows available to shareholders. Include only incremental flows. 3 major sources of cash flows: initial outlays, differential over the projects life and terminal. The riskiness of an investment project is defined as the variability of its cash flows from the expected cash flow.
Cost of capital is a key element for financial managers; essentially the rate that must be earned in order to satisfy the required rate of return of the firm’s investors. Sources and mix, as well as cost are often key determining factors in determining operational and strategic issues. Debt and equity management activities are keenly...
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