Capital Budgeting and Investment Decision

Capital Budgeting Budgeting And And Investment Decisions Lecture By: Saif Ullah Ph.D. inance Candidate !"# $#% &&$$#'%( Saifullah#'%)*ahoo.com

Bac+ground ,ost

economic activity could -e conducted through

pen ,ar+et purchases of ,aterial( Capital( And La-or Inputs( And Su-se/uent open mar+et sales of product or service outputs. But

such commodity mar+et production 0ould -e highly competitive and

only marginally profita-le

Bac+ground ,ost

economic activity could -e conducted through

pen ,ar+et purchases of ,aterial( Capital( And La-or Inputs( And Su-se/uent open mar+et sales of product or service outputs. But

such commodity mar+et production 0ould -e highly competitive and

only marginally profita-le

Bac+ground 1he

driving force of all modern economies is the e2ploitation of ne0 technologies( and the transfer of production to ever more capital intensive process( and these o-3ectives can only -e accomplished -y companies 0ith vast pool of financial( technical and human resources.

1he

most successful companies are those 0hich have developed effective programs -oth for generating investment opportunities and for selecting the most promising pro3ects from the set of opportunities availa-le.

1hose

countries 0hich have provided the most attractive -usiness investment climates have prospered relative to these 0hich have restricted or politici4ed investment decision ma+ing.

Lecture utline In

this lecture, we will discuss the techniques modern finance has developed for determining whether an investment opportunity should be exploited. vervie0 of Issues involved in capital investment analysis 1he discounted cash flo0 procedures 5ecent ,odifications 1o Capital Budgeting Analysis

1he Capital Budgeting Decision Process 1he

Capital Budgeting process involves:

6enerating

long 1erm Investment Proposals 5evie0ing( Analy4ing and Selecting from them ollo0 up on those selected 7hile

doing so attention must -e given to measuring relevant cash flo0s and applying appropriate decision techni/ues.

Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the firm’s goal of owner wealth maximization.

1ypes of Decisions 8 Capital Budgeting9inancing Decisions Capital

-udgeting investment; and financing decisions are treated separately. In

Capital -udgeting( main focus is on determining accepta-le pro3ects In inancing decisions( main focus is on arranging funds for that pro3ects.

In Capital Budgeting( 0e 0ill concentrate on i2ed Assets Ac/uisition 0ithout regard to the specific method of financing used.

7hy Capital

1he capital -udgeting process

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Basic 1erminology Independent Pro3ects •

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7hose cash flo0s are un related or independent of one another. 1he acceptance of one does not eliminate the others from further consideration

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Average Accounting rate of return

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• 1he average accounting rate of return ((! ; is the ratio of the average net income from the pro3ect to the average -oo+ value of assets in the pro3ect:

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5an+ing conflicts: ?PE vs. I55

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• 1he ?PE and I55 methods may ran+ pro3ects differently. • If pro3ects are independent( accept if ?PE H  produces the same result as 0hen I55 H r . • If pro3ects are mutually e2clusive( accept if ?PE H  may produce a different result than 0hen I55 H r .

• 1he source of the pro-lem is different reinvestment rate assumptions • ?et present value: 5einvest cash flo0s at the re/uired rate of return • Internal rate of return: 5einvest cash flo0s at the internal rate of return

• 1he pro-lem is evident 0hen there are different patterns of cash flo0s or different scales of cash flo0s.

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5elevant depreciation

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• 1he relevant depreciation e2pense to use is the e2pense allo0ed for ta2 purposes. • In the United States( the relevant depreciation is ,AC5S( 0hich is a set of prescri-ed rates for prescri-ed classes e.g.( $Fyear( Fyear( 'Fyear( and %Fyear;. • ,AC5S is -ased on the declining -alance method( 0ith an optimal s0itch to straightF line and half of a year of depreciation in the first year. • Because of the halfFyear convention that is( half of a years 0orth of depreciation in the first year;( there is al0ays one more year of depreciation four years for a threeF year asset( si2 years for a fiveFyear asset( etc.;. • It 0ould not usually -e rational to depreciate at less than ,AC5SR e2ceptions may relate to financial distress situation 0here-y not all depreciation under ,AC5S can -e used immediately

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• 1he residual income method re/uires: • "

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Suppose the Portfolio Company has the follo0ing estimates( in millions:

Principal payments

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%. 7hat are the distri-utions to o0ners if dividends are  of earnings after principal payments= #. 7hat is the value of the distri-utions to o0ners if the re/uired rate of return is %# and the -eforeFta2 cost of de-t is >= Copyright X #%$ CA Institute