Review notes_Capital Budgeting(1)

Review notes_Capital Budgeting(1) - Capital Budgeting...

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Capital Budgeting (Chapter 10) Introduction In this topic we will consider an important issue for corporations. If you look at a company, it is made up of a group of projects. A company will run a project until it matures or for a certain number of years and then shut it down. Afterwards, it will start a new project and so on. The company may also run several projects at the same time. If you look at General Motors, for example, each of GM’s products is a project. A particular model of Chevrolet is a project that would run for few years, then it would be redesigned or discontinued. The company needs to find a way to evaluate these projects and decide whether they are acceptable or not. That’s what we will be doing in this topic. We will look at three ways for evaluating projects, we will see the advantages and disadvantages of each of these methods, and decide on which is the best method to use. We will also look at the ability of these methods to rank projects. Under what circumstances would the company need to rank projects from best to worst? Mutually exclusive projects Mutually exclusive projects are projects that cannot be implemented at the same time. If one of these projects is accepted, the others are automatically rejected. Mutually exclusive means choosing one would also exclude the others. This is the main reason we need to rank projects. Limited resources The statement has been made that a company cannot accept a lot of projects because of limited resources, especially financing. This is not an accurate idea. We do have finite resources and the entire economy. If all the companies in the economy wanted funds, they would face a situation of limited funds or limited resources. However, as far as any one company is concerned, resources are not limited. Companies have to find funds for new projects because companies would not have a lot of cash un- invested. If a company has a lot of cash un-invested, it is a bad sign. Companies should utilize all of their assets. Therefore, when the company needs money for a new project, it will have to borrow or sell stock. So, the idea of limited resources is not the true limitation. However, there are times when companies find that funds are scarce. In a recession, banks are very careful about lending because a company may not be able to repay the loan. Similarly, if investors in the stock market are not optimistic about a company’s prospects, they will not buy the company’s shares. This situation occurred after September 11, 2001.
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Capital Budgeting Techniques and Project Analysis Cash flows The methods described below depend on cash flows for their analysis. Cash flow is defined as net income plus depreciation. CF = NI + Depreciation
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Review notes_Capital Budgeting(1) - Capital Budgeting...

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