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Definition
Capital Budgeting is the process of identifying, selecting, and evaluating capital
projects/long-term investments that are consistent with firm’s goal, in general case
is maximizing shareholder’s wealth. So in other words, the capital budgeting process
is used to determine and select (the most) profitable long-term (greater than one
year) projects.
Step in Process
Basic Terminology
1. Types of project
Independent Project :
Project that are unrelated to each other and allow for each project to be
evaluated based on its own profitability, because the project is not
affected by the others, the acceptance of project is not eliminate the
others.
Mutually Exclusive :
Only one project in a set of possible projects can be accepted and that the
projects compete with the others.
2. Availability of funds
Unlimited Fund :
If a firm has unlimited access to capital, the firm can accept all of
independent projects that provide an acceptable return.
Capital Rationing :
The fund of firm have only fixed number of dollars available for capital
expenditure.
3. Basic approach to make decisions
• Accept-Reject Approach
Evaluation of project that meet the firm’s minimum acceptance criteria.
• Ranking Approach
Ranking of project with the basis of some predetermined measure, such as
rate of return.
Decision Criteria
• Project accepted if PP of project less than the maximum firm’s acceptable PP
or the project have a smallest number of PP.
• Project rejected if PP of project greater than the maximum firm’s acceptable
PP or the project have a biggest number of PP.
The profitablity index is related to NPV, The NPV is the difference between the
present value of future cash flows and the initials cash outlay, and the PI is the
ratio value of future cash flows to the initial cash outlay.
Decision Criteria
• Project accepted if PI of project greater than the minimum firm’s acceptable
PI or the project have the biggest number of PI or if PI > 1.
• Project rejected if PI of project lower than the minimum firm’s acceptable PI
or the project have the smallest number of PI or PI < 1.
Decision Criteria
• Project accepted if NPV of project greater than the minimum firm’s
acceptable NPV or the project have the biggest number of NPV.
• Project rejected if NPV of project lower than the minimum firm’s
acceptable NPV or the project have the smallest number of NPV.
*i = Discount Rate
Decision Criteria
• Project accepted if IRR of project greater than the firm’s cost of
capital/required rate of return or the project have the biggest Percentage of
IRR.
• Project rejected if NPV of project lower than firm’s cost of capital/ required
rate of return or the project have the smallest number of IRR.
Initial Investment is the relevant cash outflow for a proposed project at time zero.
Operating Cash Flow is the additional cash flow a new project generates.
Terminal Cash Flow is the after tax non-operating cash flow occurring in the final year
of a project. It is usually attributable to liquidation of the project.
• Cost of New Asset: The net outflow necessary to acquire a new asset
• Installation Cost: Any added costs that are necessary to place an asset into
operation
• Installed Cost of New Asset: The cost of new asset plus its installation costs;
equals the asset’s depreciable value
• After-tax Proceeds from Sale of Old Asset: The difference between the old asset’s
sale proceeds and any applicable taxes or tax refunds related to its sale
• Proceeds from Sale of Old Asset: The cash inflows, net of any removal or clean
up costs resulting from sale of an existing asset
• Tax on Sale of Old Asset: Tax that depends on the relationship between the old
assets’ sale price and book value and on existing government tax rules
• Book Value: The strict accounting value of an asset, calculated by subtracting its
accumulated depreciation form its installed cost
Book Value = Installed cost of asset – Accumulated depreciation
• Change in Net Working Capital: The difference between a change in current
assets and a change in current liabilities
Scenario Analysis, is a method that use several estimated values for a given variable
(such as cash inflows, rate of return, cost of capital) in estimated condition that might
be happen (pessimistic, most likely, optimistic). Scenario analysist commonly focuses
on estimating what a outcome value would decrease to if an unfavorable event, or
the worst case scenario were realized.
Simulation, statistically-based behavioral approach that applies predetermined
probability distribution and random numbers to estimate risky outcomes.
CASE
ABC Industry wishes to determine whether it would be advisable for it to replace an
existing, fully depreciated machine with a new one. The new machine will have an
after tax installed cost of $600,000 and will be depreciated under a 3-year under
straight line method. The old machine can be sold today for $150,000 after taxes. The
firm is in 40% marginal tax bracket and requires a minimum return on the
replacement decision of 18%. The firm’s estimation of its revenues and expenses
(excluding depreciation) for both the new and the old machine (in $ thousand) over
the next 5 years are given below.
New Machine
Year 1 2 3 4 5
Cash 20,000 25,000 30,000 40,000 45,000
A/R 100,000 105,000 110,000 120,000 125,000
Inventory 90,000 100,000 103,000 112,000 115,000
A/P 55,000 60,000 63,000 70,000 78,000
Old Machine
Year 1 2 3 4 5
Cash 19,000 19,000 19,000 19,000 19,000
A/R 64,000 65,000 73,000 79,000 86,000
Inventory 45,000 50,000 51,000 56,000 59,000
A/P 55,000 60,000 63,000 70,000 78,000
ABC estimates that after 5 years of detailed cash flow development, it will assume
in analyzing this replacement decision that the year 5 incremental cash flows of
the new machine over the old machine will grow at a compound annual rate of 4%
from the end of year 5 to infinity.
a. Find the incremental operating cash flows (including any working capital
investment) for year 1 to 5 for ABC’s proposed machine replacement decision.
c. Show the relevant cash flows (initial outlay, operating cash flows and terminal
cash flow) for year 1 to 4 for ABC’s proposed machine replacement.
d. Using the relevant cash flows from part c, find the NPV and IRR for ABC’s
proposed machine replacement.