Capital Budgeting Framework - Capital Budgeting Unlocking...

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Capital Budgeting 1 Capital Budgeting Unlocking the Capital Budgeting Process
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Capital Budgeting 2 Capital Budgeting Capital Budgeting involves the identification, analysis, and selection of investment projects whose life spans are one year or beyond. Firms engage in capital budgeting decision-making when they assess the possibility of whether a current capital outflow (investment) will generate sufficient future cash inflows to justify the investment. The motives for making these capital outflows or investments varies. In some instances the purpose is to expand the firm’s fixed asset base so as to increase productive capacity or increase sales. In other instances the motive may be to replace or restore existing equipment so as to generate savings due to greater efficiency.
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Capital Budgeting 3 The Capital Budgeting Process Regardless of the motive behind the investment, the capital budgeting process involves the following steps: Generating project proposals consistent with the firm’s objectives. Estimating the incremental operating after-tax cash flows generated by the project. Evaluating each project based upon its estimated cash flows using sound financial techniques. Selecting project(s) based upon a value maximizing (SWM) philosophy. Periodically reevaluating previously selected projects to determine if expectations are indeed being met.
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Capital Budgeting 4 Types of Projects Projects may be mutually exclusive, independent, or dependent. If two projects are mutually exclusive this mean the decision to accept one of the projects prohibits the acceptance of the other. If project X and Y are mutually exclusive then accepting X prohibits the firm from accepting Y and accepting Y prohibits the firm from accepting X.
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Capital Budgeting 5 Types of Projects If two projects are independent this mean the decision to accept one of the projects does not impact the decision regarding the acceptance or rejection of the other. If project X and Y are independent, by accepting X the firm may either accept or reject Y and by accepting Y the firm may accept or reject X. If two projects are dependent this means the decision to accept one requires the acceptance of the other and the decision to reject one requires the rejection of the other. If project X and Y are dependent, by accepting X the firm must accept Y and by accepting Y the firm must accept X. Likewise, by rejecting X the firm must reject Y and by rejecting Y the firm must reject X.
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Capital Budgeting 6 The Capital Budgeting Checklist Measure cash flows not income flows. Measure operating cash flows not financing cash flows. Measure cash flows on an after tax basis.
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This note was uploaded on 06/04/2011 for the course ECON business taught by Professor A during the Spring '11 term at Purdue University-West Lafayette.

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Capital Budgeting Framework - Capital Budgeting Unlocking...

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