ACST101 Lecture Notes - Lecture 8: 0 (Year), Capital Budgeting, Cash Flow
29 Jun 2018
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ACST101 LECTURE 3/5/18
WK 8; FUNDAMENTALS OF CAPITAL BUDGETING
CAPITAL BUDGETING
Capital budgeting decisions are the most important investment decisions made by
management. The goal of these decisions is to select capital projects that will increase the
value of the company. Capital budgeting techniques help management to systematically
analyse potential business opportunities in order to decide which are worth undertaking.
CLASSIFICATION OFF INVESTMENT PROJECTS
Capital budgeting projects can be broadly classified into three types;
1. Independent Projects
Accepting one project won’t mean you can’t accept others (if you have the funds).
Cash flows of each unrelated.
2. Mutually Exclusive Projects
Choose between projects, e.g. a new printer. Accepting one excludes the other(s)
choice.
3. Contingent Projects
Accepting a project depends on accepting another.
BASICS TO CAPITAL BUDGETING
- The cost of capital is the minimum return that a capital budgeting project must earn
for it to be accepted. It is an opportunity cost since it reflects the rate of return
investors can earn on financial assets of similar risk.
-Capital rationing – when a company does not have the resources necessary to fund
all of the available projects. e.g. limited to $2 million capital expenditure.
Thus, the available capital will be allocated to the projects that will benefit the
company and its shareholders the most*.
*The profitability index (PI) (included in Case Study 2 but not examined in this unit) is used
to determine the combination of projects that gives best total NPV where capital rationing
exists.
NET PRESENT VALUE (NPV)
It is a capital budgeting technique that is consistent with goal of maximising shareholder
wealth.
- The method estimates the amount by which the benefits or cash flows from a
project exceeds the cost of the project in present value terms
find more resources at oneclass.com
find more resources at oneclass.com
VALUATION OF REAL ASSETS
Valuing real assets calls for the same steps as valuing financial assets;
- Estimate future cash flows
- Determine the investor’s cost of capital or required rate of return
- Calculate the present value of the future cash flows
BASICS OF NET PRESENT VALUE
The present value of a project is the difference between the present value of the expected
future cash flows and the initial cost of the project.
- Accepting a positing NPV project leads to an increase in shareholder wealth, while
accepting a negative NPV project leads to a decline in shareholder wealth
- Projects that have a NPV equal to zero implies that management will be indifferent
between accepting and rejecting the project
DIFFICULTIES
Some practical difficulties in following the process for real assets;
1. Cash flow estimates have to be prepared in-house and are not readily available
2. Estimates of required rate of return are more difficult that it is for financial assets
because no market data is available for real assets
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Capital budgeting decisions are the most important investment decisions made by management. The goal of these decisions is to select capital projects that will increase the value of the company. Capital budgeting techniques help management to systematically analyse potential business opportunities in order to decide which are worth undertaking. Capital budgeting projects can be broadly classified into three types; Accepting one project won"t mean you can"t accept others (if you have the funds). Cash flows of each unrelated: mutually exclusive projects. Accepting one excludes the other(s) choice: contingent projects. The cost of capital is the minimum return that a capital budgeting project must earn for it to be accepted. It is an opportunity cost since it reflects the rate of return investors can earn on financial assets of similar risk. Capital rationing when a company does not have the resources necessary to fund all of the available projects. e. g. limited to million capital expenditure.
