Capital Budgeting is the process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
Since CASH is central to all decisions of the firm, the expected benefits to be received from the project is expressed in terms of Cash Flows and not income flows.
Cash flows should be measured on an incremental, after-tax basis. In addition, the stress is on operating , not financing flows.
It is helpful to place project CFs into 3 categories based on timing: (1) the initial CF , (2) interim incremental net CFs , and (3) the terminal-year incremental net CF.
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Capital Budgeting: The process of planning for purchases of long-term assets.
Example:
Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?
Will the machine be profitable ?
Will our firm earn a high rate of return on the investment?
Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% .
Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% .
If IRR is greater than or equal to the required rate of return, accept .
The acceptance criterion related to the IRR method is to compare it to the required r.o.r., known as the cutoff or hurdle rate . Hurdle rate is the rate at which a project is acceptable.
If IRR is less than the required rate of return, reject .
CR also occurs when a division of a large company is allowed to make capital expenditure only upto a specified budget ceiling, over which the division usually has no control.
With such a constraint, the firm attempts to select the combination of investment proposals that will provide the greatest increase in the value of the firm subject to not exceeding the budget ceiling constraint.
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