Capital Budgeting Techniques

Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than one year. The four steps of the capital budgeting process are: Generate investment idea Analyze project ideas Create firm- wide capital budget Monitor decisions and conduct a post audit.

Categories of capital projects include: Replacement projects for maintaining the business or for cost reduction Expansion projetcs New product or market development Mandatory projetcs to meet environment or regulatory requirements Research or development

Basic Principles that must be adhered to in estimating “After tax incremental operating cash flow” Decision are based on cash flow Ignore sunk cost Include opportunity cost Include project driven changes in working capital net of spontaneous changes in current liabilities Includes effect of inflation The timing f the cash flow is important Cash flow are analyzed on an after tax basis Financing cost are reflected in the project’s required rate of return.

Independent Versus Mutually exclusive Projects Independent projects are projects that are unrelated to each other and allow for each project to be evaluated based on its own profitability. Mutually exclusive means that only one project in a set of possible projects can be accepted and that the projects compete with each other.

Projetcs sequencing concerns the opportunities for future capital projects that may be created by undertaking a current project. Capital Rationing: If a firm’s profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize, its capital expenditures with the goal of achieving the maximum increase in value for shareholders given its available capital.

NPV ( Net Present Value) NPV is the sum of the present values of a project expected cash flow and represents the increase in firm value from undertaking a project. Positive NPV projetcs should be undertaken, but negative NPV projetcs are expected to decrease the value of the firm.  Acceptance criterion: Independent Project: NPV > 0 Mutually Exclusive Projects: NPV > 0 And Highest

( IRR: Internal Rate of Return ) The IRR is the discount rate that equates the present value of the projetcs expected cash inflows and outflows and, thus, is the discount rate for which the NPV of a project is zero. A project for which the IRR is greater ( less) than the discount rate will have an NPV that is positive ( negative) and should be accepted ( not be accepted)

Payback Period and Profitability Index The payback ( discounted payback) period is the number of years required to recover the original cost of the project ( original cost of the project in present value terms.) The profitability index is the ratio of the present value of a project's future cash flows to its initial cash outlay and is greater than one when a project's NPV is positive.