Capital Budgeting

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Capital Budgeting
Introduction
Capital budgeting decisions are the most important investment decisions made by management. The objective of these decisions is to select investments in real assets that will increase the value of the firm. (Kidwell and Parrino, 2009) Project Classification Types

* Replacement projects are expenditures necessary to replace worn-out or damaged equipment. * Cost reduction projects include expenditures to replace serviceable but obsolete plant and equipment. * Safety and environmental projects are mandatory investments that may not produce revenues. * Expansion projects increase the availability of existing products and services Steps in Capital Budgeting

1. Sequence of Project Valuation
* Project cost must be determined.
* Management must estimate the expected cash flows.
* Risk of projected cash flows must be estimated.
* Given the risk of projected cash flows, the firm must determine an appropriate discount rate. * Expected cash flows must be converted to present-values. * Compare present-value of expected cash inflows with the required outlay. 2. Cash Flow Estimation

* Expected cash inflows and outflows must be estimated within a consistent and unbiased framework

Capital budgeting techniques help management systematically analyze potential business opportunities in order to decide which are worth undertaking. (Kidwell and Parrino, 2009) There are many techniques used in the process of capital budgeting. The most common methods are payback, discounted payback period, net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR) and modified internal rate of return (MIRR).

Payback Period
The payback period is defined as the number of years that it will take a project to recover the initial investment of a company. This period can be easily calculated by adding the years before cost recovery to the remaining cost to recover divided by the cash flow during the year. The payback period is not a sophisticated capital budgeting technique. With using the payback period for evaluating projects, a project is accepted if the payback period is below a special threshold. (Kidwell and Parrino, 2009)

The payback measures the length of time it takes a company to recover in cash its initial investment. This concept can also be explained as the length of time it takes the project to generate cash equal to the investment and pay the company back. It is calculated by dividing the capital investment by the net annual cash flow. If the net annual cash flow is not expected to be the same, the average of the net annual cash flows may be used. |

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For the Cottage Gang, the cash payback period is three years. It was calculated by dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000 inflows - $200,000 outflows)  |

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The shorter the payback period, the sooner the company recovers its cash investment. Whether a cash payback period is good or poor depends on the company's criteria for evaluating projects. Some companies have specific guidelines for number of years, such as two years, while others simply require the payback period to be less than the asset's useful life. When net annual cash flows are different, the cumulative net annual cash flows are used to determine the payback period. If the Turtles Co. has a project with a cost of $150,000, and net annual cash inflows for the first seven years of the project are: $30,000 in year one, $50,000 in year two, $55,000 in year three, $60,000 in year four, $60,000 in year five, $60,000 in year six, and $40,000 in year seven, then its cash payback period would be 3.25 years. See the example that follows. |

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The cash payback period is easy to calculate but is actually not the only criteria for choosing capital projects. This method ignores differences in the timing of cash flows during the project and...
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