12 7 13 what is the capital budgeting capital

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7 13 What is the Capital Budgeting? Capital Budgeting is the process of determining which real investment projects should be accepted and given an allocation of funds from the firm. Capital Budgeting is used to make the Investment Decision To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of highest importance. 14 Use of funds decisions important to the financial manager Financial Manager Financial Markets Real Assets Financing Decision Investment Decision Returns from Investment Returns to Security Holders Reinvestment Refinancing
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8 15 What is investment appraisal? Before committing to high levels of capital spend, companies normally undertake investment appraisal. Investment appraisal has the following features: 1. Assessment of the level of expected returns earned for the level of expenditure made 2. Estimates of future costs and benefits over the project's life. When a proposed capital project is evaluated, the costs and benefits of the project should be evaluated over its foreseeable life (expected useful life ). This means that estimates of future costs and benefits call for long-term forecasting. 16 Investment Appraisal
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9 17 Payback Period The length of time taken to repay the initial capital cost Requires information on the returns the investment generates e.g. A machine costs £600,000 It produces items that generate a cash of £5 each on a production run of 60,000 units per year Payback period will be 2 years Initial Investment Payback = ------------------------------------------ annual cash flow 18 Payback Period Payback method and uneven cash flow: In the above example we have assumed that the projects generate even cash inflow (same cash inflow during each period) but when projects generate uneven cash inflow (different cash inflow in different periods), the payback period formula given above cannot be used to compute payback period. To understand the analysis of a project that generates uneven cash inflow, consider the following example:
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10 19 Payback Period Example An investment of $200,000 is expected to generate the following cash flows in six years: Year Net cash flow 1 $30,000 2 $40,000 3 $60,000 4 $70,000 5 $55,000 6 $45,000 Required: Compute payback period of the investment. Should the investment be made if management wants to recover the initial investment in 3 years or less? 20 Payback Period Solution: Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback period. We can compute the payback period by computing the cumulative net cash flow as follows: Year Net cash flow Cumulative net cash inflow 1 $30,000 $30,000 2 $40,000 $70,000 3 $60,000 $130,000 4 $70,000 $200,000 5 $55,000 $255,000 6 $45,000 $300,000 Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal to initial amount of investment.
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11 21 Each of following mutually exclusive projects involve an initial cash outlay of $240,000. The estimated net cash flows for the projects are: Year Project A ($) Project B ($) 1 140,000 20,000 2 80,000 40,000 3 60,000 60,000 4 20,000 100,000 5 20,000 180,000 Calculate the payback period for both projects. Which project should be chosen? Why?
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