Capital Budgeting
Yes. Most of them. They last more than a year, or more than a normal operating cycle of the business.
Are capital investment decision involve long-term commitments?
acceptance of one proposal, will mean automatic rejection of another proposal.
Mutually exclusive projects
1. It does not consider the time value of money. All cash received during the payback period is assumed to be of equal value in analyzing the project. 2. It gives more emphasis on liquidity rather than on profitability of the project. (return *of* investment rather than return *on* investment) 3. It does not consider the salvage value of the project. 4. It ignores the cash flows that may occur after the payback period.
What are the advantages of payback method? (in evaluating capital expenditure)
1. Payback method is simple to compute and easy to understand. There is no need to compute or consider any interest rate. One has to answer the question: "How soon will the investment cost be recovered?". 2. It gives information about the liquidity of the project. 3. It is a good surrogate for risks. A quick payback period indicates a less risky project.
What are the advantages of payback method? (in evaluating capital expenditure)
Cost of borrowing, current prices of stocks and government rules and regulations.
What are the factors to be considered in the computation of cost of capital.
1. Net Investment 2. Net Returns 3. Cost of Capital
What are the three capital investment factors?
the result shown by the DCF methods must be given more weight.
What if problems in ranking arise because of the conflicting results by the evaluation methods?
the result shown by the net present value method or, better still, by the profitability index, should be preferred to the result shown by the discounted cash flow rate of return (DCFRR) method.
What if ranking problems still exist despite the use of the DCF methods?
Capital investment decisions are more difficult to reverse than short-term decisions. For instance, the management of a company decides to increase the selling price in anticipation of an increase in demand for one of its products. If the decision turns out to be a failure, management can easily roll back the selling price to the original amount. In capital investment projects, for instance, the management decides to buy additional heavy equipment in anticipation of an increase in demand for a product line. If the expected increase in demand does not materialize, the management may dispose or sell them. In this case, management must hope and say that they find a buyer who would be willing to but the heavy equipment for at least at their book value.
What is the difference of short-term decisions and capital investment decisions in reversal?
Net present value/Investment
What is the formula for net present value index?
Evaluation of the capital investment proposal
What is the most difficult part of the capital budgeting process?
the firm's cost of capital rate is more realistic, hence, theory suggests resorting to the NPV method.
What is the most suggested method?
should be based on the result shown by the profitability index, which, actually, is just a refinement of the NPV method.
What should be the basis of final decision?
Each of the proposals must be evaluated using the different techniques,
When a firm is faced with a problem of choosing the best project from a number of alternative proposals, what would the management should do?
The nature and characteristics of capital investment decisions warrant a careful analysis of investment alternatives. A set of systematic capital budgeting procedures is necessary to ensure that all capital investment proposals are evaluated considering the organization's goals and policies so that the best alternative is undertaken.
Why Capital Budgeting Process is necessary?
Capital investment decisions involve critical cases that require thorough evaluation and analysis. The penalty for an unwise decision is usually severe.
Why is that most of the capital investment decisions are made by top-level management?
The longer the time period involved in a project, the more difficult it is to make predictions regarding the project's revenues and expenses. Thus, the more uncertain we are about the budget estimates. Naturally, because of such uncertainty factor, a greater amount of risk may be expected.
Why is there a greater amount of risk expected in capital investment projects?
Net Present Value Method.
assumes that earnings are reinvested at a rate of return equal to the firm's cost of capital.
DCFRR method
assumes that earnings are reinvested at a rate of return of the particular project being considered.
According to their desirability and acceptability as dictated by the evaluation methods used.
how products are being ranked?
Bonds- after tax rate of interest Preferred stock- dividend per share divided by the present market price of the preferred stock. Common stock & retained earnings- Earnings per share (after tax and preferred dividends) divided by the current market price of the common stock.
how to compute cost of capital in bonds, preferred stock and common stock & retained earnings.
Economic life
is the period of time during which the asset can provide economic benefits or positive cash inflows and it is also considered in computing cost of capital instead of useful life.
Discounted cash flow rate of return
refers to the interest or discount rate that equates the present value of the returns or net cash inflows with the investment. When we use this as a discount rate, the present value of cash inflows will be equal to the present value of cash outflows, so that the resulting net present value is equal to zero.
The Time adjusted rate of return method
this method involves the computation of a time-adjusted rate of return, also known as a adjusted rate of return, internal rate of return (IRR), adjusted rate of return or discounted cash flow rate of return (DCFRR)
