Key Principles in Capital Budgeting: Criteria for Investment Projects Net Pesent Value Internal Rate of Return Payback Profitability Index
Finding Cash Flows
Financial management is largely concerned with financing, dividend and investment decisions of the firm with some overall goal in mind. Corporate finance theory has developed around the goal of shareholder wealth maximization. Financing decisions deal with the firm’s optimal capital structure in terms of debt and equity. Dividend decisions relate to the form in which returns generated by the firm are passed on to equity-holders. Investment decisions deal with the way funds raised in financial markets are employed in productive activities to achieve the firm’s overall goal.
Capital budgeting is primarily concerned with sizable investments in long-term assets. These assets may be tangible (property, plant or equipment) or intangible ones such as new technology, patents or trademarks. They are generally long-lived projects with their benefits or cash flows spreading over many years. As such, capital budgeting decisions have a major effect on the value of the firm and its shareholder wealth.
Capital Budgeting: An Introduction
Capital budgeting: one of the most important functions a financial manager must perform, required by the strategic planning and expansion of operations by allocating financial resources for the acquisitions of physical resources that will produce incremental future cash-flow and create value for shareholders:
Corporate investment projects:
to maintain the business - made without detailed analysis for cost reduction or efficiency purposes – fairly detailed analysis
Expansion of existing products or markets – complex decision process that require an explicit forecast of future demand, detailed analysis Expansion into new products or markets - similar detailed analysis Regulatory, safety and/or environmental projects – mandatory investments for many industries, and often accompany new revenue producing projects
The same ideas also apply to personal investment decisions (for example buying a car vs. leasing it, renting an apartment vs. buying one). Maria Ruiz
Capital Budgeting Key Principles
Rule 1 : Cash flows after taxes, not net income, is the proper basis for analysis Only the incremental cash flows should form part of an investment decision Sunk Costs should not be included in the analysis Only incremental Cash Flows are analyzed: externalities should be included (i.e. cannibalization)
Rule 2 : Cash Flow are based on Opportunity costs Rule 3 : Timing of cash flows is critical Rule 4 : Cash Flows are analyzed on an after-tax basis Rule 5: Financing costs are already reflected in the projects required rate of return
Sunk costs: Cost that has already been incurred
R&D expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in all. What are cash flows for the project?
Opportunity cost: what a resource is worth in its next-best use A company uses idle property, what should it use as the investment outlay? (pruchase price, current market value, nothing ?)
Incremental cash flows: difference between projected cash flows with and without the project
Externality: effect of an investment on other things besides the investment itself Ilustration of Cannibalism: A proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenues. How much cash flow should the company consider?
Conventional vs. Non conventional cash flows:
Conventional: initial outflow followed by a series of inflows Non conventional: different
Illustration: Underutilized Resources