Capital Budgeting

Capital Budgeting - Capital Budgeting This lecture provides...

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Capital Budgeting This lecture provides an overview of the capital budgeting process and shows how to estimate the relevant cash flows associated with an investment project and evaluate those cash flows I. Capital expenditures are important to a firm both because they require sizable outlays and because they have a significant impact on the firm’s long-term performance. A. Capital budgeting is the process of planning for purchases of assets whose returns are expected to continue beyond one year. B. A capital expenditure is a cash outlay, which is expected to generate a flow of future cash benefits. Normally, a capital project is one with a life of more than one year. C. Capital budgeting models are used to evaluate a wide variety of capital expenditure decisions, including: 1. investments in assets to expand an existing product line or to enter a new line of business. 2. replacement of an existing capital asset. 3. expenditures for an advertising campaign. 4. expenditures for research and development. 5. investments in permanent increases in inventory or receivables levels. 6. investments in education and training. 7. refunding an old bond issue with new bonds paying a lower interest rate. 8. leasing decisions. 9. merger and acquisition decisions. D. The firm's cost of capital is the combined cost of funds from all sources. The cost of capital is also called the investors' required rate of return (RRR), because it is the minimum rate of return that must be earned on the capital invested in the firm. The required rate of return helps provide a basis for evaluating capital investment projects. E. Projects under consideration may be independent of each other or have some types of interdependencies. 1. An independent projec t is one whose acceptance or rejection has no effect on other projects under consideration. 1
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2. Two projects are mutually exclusive if one or the other can be accepted, but not both. 3. A contingent project is one whose acceptance is contingent upon the adoption of one or more other projects. 4. One additional complication is capital rationing , which occurs when the firm has a limited total amount of dollars available for investment and the outlay for profitable investments exceeds this limit. On the other hand, when the firm has sufficient funds available to invest in all profitable projects, we say the firm is operating without a funding constraint. III. We are going to discuss the general theory of capital budgeting, before we do an actual example. Don't spend too much time on the theory, it's mainly for support of the example that follows. The initial step in the capital budgeting process is generating capital investment project proposals. A. The process of soliciting and evaluating investment proposals varies greatly among firms.
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