Capital Budgeting

Capital Budgeting - Capital Budgeting Capital Models &...

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1 Capital Budgeting Capital Budgeting Models & Risk Models & Risk Adjustment Adjustment Stony Brook College of Business BUS 330 V. Giardini
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2 Capital Budgeting Overview Capital Investment An expenditure of funds made in the hope of realizing benefits that are expected to occur over the extended future. Budgeting Techniques Cash Flow Estimation Cost of Capital (Discount Rate)
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3 Project Types and Risk Project Types and Risk Projects fall into three general categories characterized by increasing risk: Replacement Expansion New Venture STAND-ALONE AND MUTUALLY EXCLUSIVE PROJECTS The Stand-Alone Decision Is the project a good idea if there's no competition for the resources to do it The Mutually Exclusive Decision Selecting either project excludes the other Choosing among different ways to do something or among separate projects competing for limited resources
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4 PROJECT CASH FLOWS PROJECT CASH FLOWS The first step in capital budgeting is to represent all projects as a series of incremental cash flows Example: A new venture takes an initial investment of $50,000, will lose $10,000 in the first year, and earn $15,000 per year for five years C 0 ($50,000) C 1 ($10,000) C 2 $15,000 C 3 $15,000 C 4 $15,000 C 5 $15,000 C 6 $15,000 The typical pattern involves outflows first and inflows later
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5 THE COST OF CAPITAL THE COST OF CAPITAL The average rate of return the firm pays to its long term investors for the use of their money. Intuitive Purpose : An investment makes sense only if it earns more than the cost of funds put into it. A weighted average concept where the weights are the proportionate amounts invested in each kind of capital Portion Return Equity .75 x 10% = 7.5% Debt .25 x 8% = 2.0% Weighted Average Cost of Capital 9.5%
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6 CAPITAL BUDGETING TECHNIQUES CAPITAL BUDGETING TECHNIQUES Payback period Net Present Value (NPV) Internal Rate of Return (IRR) Each involves calculating a number for every project under consideration and applying decision rules to those numbers to make accept or reject choices
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7 PAYBACK PERIOD PAYBACK PERIOD Measure the time it takes for the project to "break even" in terms of undiscounted cash flows Example: Year 0 1 2 3 4 Cash Flow (C i ) ($200,000) $60,000 $60,000 $60,000 $60,000 Cumulative Cash Flow ($200,000) ($140,000) ($80,000) ($20,000) $40,000 Payback Period = 3.33 years
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This note was uploaded on 02/15/2012 for the course GERM 200 taught by Professor Kuhmar during the Spring '10 term at SUNY Albany.

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Capital Budgeting - Capital Budgeting Capital Models &...

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