30-09-2013, 02:46 PM
Capital Budgeting
Capital Budgeting.ppt (Size: 133.5 KB / Downloads: 126)
Introduction
Capital Budgeting is the process of determining which real investment projects should be accepted and given an allocation of funds from the firm.
To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance.
Discounted Cash Flow (DCF) Techniques
The main DCF techniques for capital budgeting include: Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI)
Each requires estimates of expected cash flows (and their timing) for the project.
Including cash outflows (costs) and inflows (revenues or savings) – normally tax effects are also considered.
Each requires an estimate of the project’s risk so that an appropriate discount rate (opportunity cost of capital) can be determined.
The discussion of risk will be deferred until later. For now, we will assume we know the relevant opportunity cost of capital or discount rate.
Sometimes the above data is difficult to obtain – this is the main weakness of all DCF techniques.
NPV using the Calculator
Use CFj key to enter the cash flows.
Use Nj key to enter the number of times a cash flow repeats.
Enter the opportunity cost of capital in the I/YR key.
Use the NPV function to compute NPV
Note: before starting the evaluation of a new project, clear previous data and ensure the calculator is set to 1 P/Yr.
Internal Rate of Return (IRR)
IRR is the rate of return that a project generates. Algebraically, IRR can be determined by setting up an NPV equation and solving for a discount rate that makes the NPV = 0.
Equivalently, IRR is solved by determining the rate that equates the PV of cash inflows to the PV of cash outflows.
Method: Use your financial calculator or a spreadsheet; IRR usually cannot be solved manually.
If IRR ≥ opportunity cost of capital (or hurdle rate), then accept the project; otherwise reject it.
IRR using the Calculator
Use CFj key to enter the cash flows.
Use Nj key to enter the number of times a cash flow repeats.
Use the IRR function to compute IRR
Note 1: before starting the evaluation of a new project, clear previous data and ensure the calculator is set to 1 P/Yr; however, if you have already entered the cash flows for an NPV analysis, you do not need to reenter them – they are in your calculator already and can be used for the IRR calculation.
Note 2: You do not need to input the opportunity cost of capital to calculate the IRR, however, you need the opportunity cost to make your accept/reject decision.
IRR: Strengths and Weaknesses
Strengths
IRR number is easy to interpret: shows the return the project generates.
Acceptance criteria is generally consistent with shareholder wealth maximization.
Weaknesses
Requires knowledge of finance to use.
Difficult to calculate – need financial calculator.
It is possible that there exists no IRR or multiple IRRs for a project and there are several special cases when the IRR analysis needs to be adjusted in order to make a correct decision (these problems will be addressed later).
Midterm Exam 1 – Advice
If in doubt of a question’s wording, ask for clarification!
Some questions will be similar to lecture examples, assignments, and text questions, BUT, beware some questions will be quite different from those you have seen previously – to test whether you really understand the concepts and can apply them to new situations.
Time management is important; don’t waste time on questions – do easier ones first if think you are going too slowly.
Don’t forget your formula sheet – double sided 8.5 by 11 inches; no word-processed or photocopied info is allowed; any hand-written content can be included.