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Chapter 11 - Capital budgeting, Decision Criteria

Chapter 11 - Capital budgeting, Decision Criteria - Brigham...

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Brigham and Daves (2004) , Intermediate Financial Management Chapter 11 - Capital budgeting: Decision Criteria Overview of capital budgeting o Capital budgeting is the decision process that managers use to identify those projects that add value o Important since o Capital budgeting decisions define its strategic direction o Results of those decisions continue for many years → flexibility ↓ o Poor capital budgeting can have serious financial consequences o Firm growth and ability to remain competitive and to survive depend on the flow of new ideas and better products → look for new projects Project classifications o Analysing capital expenditure proposals is not a costless operation → categorization of projects and then analyse those in each category somewhat differently 1. Replacement: maintenance of business 2. Replacement: cost reduction 3. Expansion of existing products and markets 4. Expansion into new products or markets 5. safety and/or environmental projects 6. R&D 7. Long-term contracts o In general, only a few simple calculations and supporting documents are required for replacement decisions o More detailed analysis is required for cost-reduction replacements, for expansion in existing and new products and markets Payback period o Defined as the expected number of years required to recover the original investment o Payback = Year before full recovery + [(Unrecovered cost at start of the year)/(CF during the year)] o The shorter the payback period, the better the project o Mutually exclusive – if one project is taken, the other one must be rejected o Independent – projects whose cash flows do not affect one another Discounted payback period o Similar to regular payback period except that e expected cash flows are discounted by the project’s cost of capital o Defined as the number of years required to recover the original investment from discounted net cash flows Evaluating payback and discounted payback o Payback is a type of “breakeven” calculation in the sense that CFs come in at the expected rate until the payback year o However, regular payback does not consider the cost of capital to finance the project (discounted payback does) o Important drawback of both methods is that they ignore CFs that are paid or received after the payback period o But provides information on how long funds will be tied up in the project ( liquidity ) and since cash flows are expected in the nearer future ( less risky ) - 1 -
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Brigham and Daves (2004) , Intermediate Financial Management Chapter 11 - Capital budgeting: Decision Criteria Accounting rate of return o
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