Capital Budgeting

Topics: Cash flow, Net present value, Corporate finance Pages: 6 (788 words) Published: November 19, 2013
WHAT IS CAPITAL BUDGETING?
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Decision making process of selecting and evaluating longterm investments. Examples include the decision to replace equipment, to develop new product, or to build new shop at
a new branch of operations.
It is very crucial for companies to make the right decisions because these projects require a huge amount of cash
outflow committed for many years. A right decision will
increase the firm’s value as well as the shareholders’ wealth. A wrong decision will result in a drop in firm value as well as shareholders’ wealth.

Capital Budgeting

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Capital Budgeting Process
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Generating long-term investment proposals consistent with a
firm’s long-term objectives
Estimating the relevant after-tax incremental cash flows for these project proposals
Evaluating these cash flows
Selecting the project that will maximize shareholders’
wealth
Reevaluating these projects from time to time for control
purposes and carrying out post-audits for completed
projects.

Capital Budgeting

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TYPES OF PROJECTS
1.

Independent projects – are projects whose cash flows are
not affected by the acceptance or nonacceptance of other
projects. If a firm has unlimited funds to invest, all the
independent projects that meet its minimum investment
criteria can be implemented. For example, a firm with
unlimited funds may be faced with 3 acceptable independent
projects – (1) installing air conditioner in the plant, (2) acquiring a small supplier, and (3) purchasing a new
computer system.

Capital Budgeting

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TYPES OF PROJECTS
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Mutually exclusive projects- are projects that have the
same functions and therefore compete with one another. The
acceptance of one of a group of mutually exclusive projects
eliminates all other projects in the group from further
considerations. For example, the installation of a conveyor
belt system in a warehouse and the purchase of a fleet of
forklifts for the same warehouse. Another example, a firm in need of increased production capacity could obtain it by (1) expanding its plant, (2) acquiring another company , or (3)
contracting with another company for production.

Capital Budgeting

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TYPES OF CAPITAL BUDGETING DECISION

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Expansion – through acquisition of fixed assets. Examples : purchase of additional physical facilities such as additional property and plant
Replacement or renewal of worn-out assets. Renewal may
involve rebuilding, overhauling or retrofitting an existing
machine or facility.
Other purposes such as instalment of pollution-control and
safety devices mandated by the government.

Capital Budgeting

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GUIDELINES FOR CAPITAL BUDGETING
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Use cash flows and not accounting profit.
 Cash flows reflect amount of cash received and cash paid out. Accounting profit involves items such as accrued
expenses and depreciation, which do not involve any
flow of cash but are being subtracted from revenue
2. Focus on incremental cash flows.
 These represents the changes in the firm’s total cash
flows that occur as a direct result of accepting the project.

Capital Budgeting

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GUIDELINES FOR CAPITAL BUDGETING
 After-tax cash flows are used , as these are the cash flows that are available for reinvesting in the firm or paying
shareholders.
3. Consider the synergistic effect. The synergistic effects
occurs when products are complementary in nature. Any
cash flow to any part of the company that may result from
the decision at hand.
4. Consider the loss of revenue from existing products (occur when the products are competitive in nature)

Capital Budgeting

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GUIDELINES FOR CAPITAL BUDGETING
5.

Ignore sunk cost
 A sunk cost is a cash flow that has incurred and cannot be recovered regardless of any decision that you made.
6. Include opportunity cost
 An opportunity cost is cash flows that are foregone in
relation to one project by accepting...
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