Capital Budgeting
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
1
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
2
TYPES OF PROJECTS
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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
3
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
1.
2.
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
1
Capital Budgeting Process
1.
2.
3.
4.
5.
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
2
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
3
TYPES OF PROJECTS
2.
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