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Capital budgeting-

Capital Budgeting Decisions:


Learning Objectives:

1. Evaluate the acceptability of an investment project using the net present value
method.
2. Evaluate the acceptability of an investment project using the internal rate of return
method.
3. Evaluate an investment project that has uncertain cash flows.
4. Rank investment projects in order of preference.
5. Determine the payback period for an investment.
6. Compute the simple rate of return for an investment.
7. Understand present value concepts and the use of present value tables.
8. Include income taxes in a capital budgeting analysis.

capital budgeting
Page historylast edited by Brian D Butler 1 mo ago

Capital Budgeting
(spending money on product development)

This is the "fun" part of investing / Finance. It means that you have money, and you are
trying to decide which product development project to invest in. In its essence, capital
budgeting is about finding the projects that will give you the "biggest bang for the buck",
measured by net present value analysis, combined with qualitative analysis techniques.

Table of Contents:
- Hid 1. Capital Budgeting
e i. How does "Capital Budgeting" relate to other areas of Finance /
Investing?
2. How to Evaluate Projects
i. 1. Quantitative Techniques
a. NPV analysis (net present value)
b. IRR analysis:
c. Using "Options" Analysis to pick the right project:
ii. 2. Qualatative Analysis (looking outside of NPV)
a. Qualitative factors to consider:
b. Why consider these factors?
3. Optimum Product Mix:
i. Using MS Excel
4. Links from KookyPlan:

How does "Capital Budgeting" relate to other areas of Finance /


Investing?
Brief summary: Project finance decisions (project finance) is the decision process about
whether to invest in new machinery, building plants, expanding warehouses and so on. For
this kind of project investing, people will generally look at net present value analysis to
decide if the project should go forward.

This is different than the capital structure decision (how much debt should I take on), the net
working capital decision (how much cash do I need to finance ongoing Operations),
the credit management decision (how much to invest in customers), and Human
Resources decision (how much to invest in employees).

Capital Budgeting involves the "left-hand side of the balance sheet", or where the assets
are. Its name is simple: you have capital, and you are in charge of budgeting it, ie deciding
which projects to invest in. In its most simple form, capital budgeting is what Venture
Capital is all about. But it is also about internal corporate decision making. Think GE here
(how would a company like GE decide which projects/ companies / divisions to invest
in?...this is capital budgeting).

How to Evaluate Projects


see financial modeling

1. Quantitative Techniques

The core of capital budgeting is learning how to make good financial decisions when
presented with choices for how to spend your money. In the end, there are many financial
modeling techniques such as "internal rate of return"(IRR), and "payback period method",
but when comparing two projects on a quantitative analysis...always use net present
value to choose the better project

Using the skills of financial modeling, the analyst will look at the sum of cash
inflows (revenues) and outflows (costs) in the full life cycle of the product. These cash flows
normally start out negative with development costs, then ramp up costs, marketing and
support costs and finally product costs. Soon thereafter, you hope that the product will be
accepted by customers, and you will then begin the cash inflows through revenues.

With the sum of 4 negative cash outflows, and 1 positive cash inflow...all occuring at
different times...how do you determine if the project is a good one (and worth spending
money on)?

The most commonly used technique for capital budgeting projects such as these is NET
Present Value (NPV), which figures out the present day value in todays dollars of all of the
expected future cash flows.

NPV: While the techniques of net present value may be very valuable in evaluating a project
based solely on the financial numers, a manager should be more alert to the other many
factors that influece the qualitative evaluation of project finance. Why use NPV analysis
during product development? Because it helps to provide objective evaluations of projects
and also brings a level of systematic control and accountability to corporations making
project finance decisions. Problems with NPV are numerous, and are fully outlined in our
discussion on capital budgeting
NPV analysis (net present value)

Net present value analysis is the classic financial modeling method taught at most MBA
business schools. Its a technique that allows managers to compare future cash flows in
terms of todays dollars. Its allows managers to put a dollar value on expected future cash
flows, and to compare one project vs another. When comparing projects on NPV analysis,
the one with the higher NPV always wins.

The problem with this method is that it seems very precise. The output is a very exact
number, and managers can be fooled into thinking that precise is the same thing as
accurate. It is not. The NPV analysis can be very inaccurate, depending upon which
assumptions you base your calculations. If you change one assumption (future growth,
market size, competition, etc), it can dramatically change your NPV output.

So, if you are ever presented with an NPV analysis, please take a moment to critically
challenge the underlying assumptions.

Another problem with NPV, is that it depends upon which discount rate the analyst has
chosen. But, this discount rate can be very difficult to estimate properly. The trouble is
that different projects might be more attractive than others depending upon which discount
rate is chosen for the analysis. Be very careful when presented with an NPV analysis that
compares two projects, and digg deep into how the discount rate was calculated. One
project might be better at lower interest rates, but another is better at higher rates.

For more discussion about the benefits/ troubles of NPV analysis, please visit our discussion
on net present value

IRR analysis:

Internal Rate of Return analysis tries to overcome some of NPV's weaknesses. Specifically, it
seeks to help the novice analyst to avoid needing to make assumptions about the discount
rate (which is needed for NPV, but not for IRR calculations). This is the second technique
often used in financial modeling.
While IRR is conceptually easy to understand, it is not really a good tool to use for capital
budgeting decisions. You should never compare IRRs directly from one project to
another...you will make mistakes. This is because the better project (financially speaking) is
not the one with the highest internal rate of return, but the one with the highest overall
NPV. The trouble with IRR is that it does not take into consideration the overall size of the
project. For example, a tiny project might give you a 45% rate of return, but it might not be
possible to scale up that project to be meaningful in terms of overall return. On the other
hand, there may be million dollar investment that you can make and get the overall best
return.

But, if you are determined to use IRR for capital budgeting, then here is what you
do.....compare the incremental cash flows of the two projects, and calculate the IRR and NPV
of that incremental cash flow. Take the project with the larger initial cash outflow, and
subtract the smaller project. If both projects have the same initial outflow of money, then
look to the first cash flow and subtract so that the result of that subtraction is a negative
number. Then do the IRR of the incremental cash flow. That IRR is the break even point.
That is the point above which you choose one project, and below which you choose the
other. This works because IRR figures out the discount rate at which NPV is =0. But, in this
case, we are comparing two projects against each other, so it figures out the break even
point.

Using "Options" Analysis to pick the right project:

Managers that use textbook NPV analysis are ignoring the real world facts that there is the
option to make new decisions at a later date. For this reason, project finance is a bit more
complicated than simple NPV analysis would make you believe.

please see our discussion on real options for more on this topic.

2. Qualatative Analysis (looking outside of NPV)

In addition to the measureable factors such as cash flows, there are other important factors
that may be more difficult to measure, but that still have a major effect on the decision
about whether to develop a project or not. There are dynamic and competitive
environment factors that need to be considered, as some projects (most projects)
are strategic (and not just financial) in their nature.

But just looking at the quantitative measures such as NPV will often lead managers to miss
the best investing opportunities. In addition to business-school MBA-like calculations about
net present value of cash flows, a good manager should also consider whether or not the
investment in this one project could act as a platform for future innovation and growth (in
essense, an option for future growth). Also, it needs to be considered how the project fits
into the competitive environment (see discussion about flanking strategy), and with
the strategic position of the company. Looking only at NPV will often lead managers to
make bad decisions.

Qualitative factors to consider:


1. interaction of project and Firm - will knowledge obtained from this project spillover,
and help the firm as a whole? Does the firm have spare capacity to take on this
project?
2. interaction of project and Market - how will competitors react to the development of
this project?
3. interaction of project and macroeconomic environment - how will exchage
rates change? How will that effect profitability globally? foroutsourcing?

Why consider these factors?

• Ceteris paribus: the assumption that "all other things being equal": This is a
fundamental assumption underlying all NPV analysis, and it ignores the three
qualitative factors listed above. It assumes that decisions made by the company do
not affect competitors, and that competitors reactions do not affect the profitablity of
the project. It assumes that the macro economic environment will still be the same
in the future, and it assumes that changes in macroeconomic factors do not change
the decision criteria for the project. This is clearly wrong, but is essential component
of most financial models (such as net present value NPV analysis).
• For more discussion about how to use Qualitative factors when looking at projects,
please visit our page on financial modeling
Corporate finance[1] finance dealing with financial decisions business enterprises make and the tools and
analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate
value [2] while managing the firm's financial risks. Although it is in principle different frommanagerial
finance which studies the financial decisions of all firms, rather than corporations alone, the main
concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques. Capital
investment decisions are long-term choices about which projects receive investment, whether to finance
that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other
hand, the short term decisions can be grouped ". This subject deals with the short-term balance of current
assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing
and lending (such as the terms on credit extended to customers).

The terms corporate finance and corporate financier are also associated with investment banking. The
typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate
type of capital that best fits those needs.

(In the UK, the terms “corporate finance” and “corporate financier” tend to be associated with transactions
in which capital is raised in order to create, develop, grow or acquire businesses.)
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's
long term investments such as new machinery, replacement machinery, new plants, new products, and
research development projects are worth pursuing. It is budget for major capital, or investment,
expenditures.[1]

Many formal methods are used in capital budgeting, including the techniques such as

 Accounting rate of return


 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project Techniques
based on accounting earnings and accounting rules are sometimes used - though economists consider
this to be improper - such as the accounting rate of return, and "return on investment." Simplified and
hybrid methods are used as well, such as payback period and discounted payback period.

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken
from an enterprise's financial statements. Often used in accounting, there are many standard ratios used
to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may
be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a
firm's creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various
companies.[1] If shares in a company are traded in a financial market, the market price of the shares is
used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such
as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less
than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that
are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one
can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The
reciprocal expresses the same information, but may be more understandable: for instance, the earnings
yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20
corresponds to an earnings yield of 5%.

Working Capital management


Capital structure
RATIO ANALYSIS
Financial Modelling of a company for last 10 years, leading to a analysis of its ratios.
Liquidity Analysis..
Comparative Valuation.
corporate lending
Industry analysis and company analysis on a scenario basis, competitiveness, growth potential and
credit analysis
debtor management
Research in Risk management, Banking, Derivatives etc
. International Banking, Foreign Exchange, Monetary Economics, Micro Finance, Rural Finance
The Effects of Financial Constraints on Corporate Investment Decisions and Demand for Liquidity
Corporate finance
Capital budgeting
Virtual finance
Financial Planning and forecasting
Structured Finance
Computational finance
Optimization Methods in Finance
Dependence on external finance: an inherent industry characteristic?
Project Finance as a Tool for Growth
Creating Value through Financial Management
Cost Reduction and Control
New Financial Approaches for the Economic Sustainability in Manufacturing Industry
Activity-based costing and management
Fundamental Analysis to Assess Earnings Quality
EQA Earnings quality Analysis
Zero Base Budgeting
international business
international finance
investment banking
investment management
VENTURE CAPITAL
1.)JIT (just in time)
2. EOQ
3. ABC analysis
4. vendor performance
5. quality circle
6. TQM
7. ISO 9000
8. value engineering
9. centralize purchase
10. management audit
11. company analysis with ratio/fund flow
12. study of stock exchange
13. role of SEBI
14. joint venture
15. takeover
16. merger
17. marginal cost as management tool
18. product life cycle
19. media plan
20. test marketing
21. export pricing
22. role of small scale industries in developing nation
23. role of SIDBI
24. role of EXLM bank
25. study of financial institute
26. mutual fund
27. Privatization – insurance, road, ports etc.
28. waste management
29. trade union movement in India
30. labour welfare scheme
31. working capital management
32. cash management / fund management
33. importance of budget
34. invisible exports
35. tourism industries
36. brand equity
37. bench marking
38. co-operative movement in Agro-product
39. marketing Agro-product
40. DOT COM company in future
41. IT Parks
42. South East Asian origin
43. FDI
44. Regional Grouping / Trade Block
45. SEZ
46. packing need
47. social forestory
48. comparative study of industries (either financial angle or
marketing angle or techno angle)
49. marketing of SSI produt
50. warehousing
51. transport
52. IATA – role function
53. communication and custom service
54. universal bank
55. credit cards
56. health economics
57. body language
58. role of financial institutions in industrial development
59. NBFC's
60. GDR's / ADR's
61. debt markets
62. securitization
63. commercial paper
64. forex and treasury
65. performance appraisals
66. private sector banks
67. comparative study of 2 financial institutions
68. need and importance of financial analysis
69. tax and non tax revenues
70. deficit financing
71. corporate finance
72. corporate restructuring
73. telebanking
74. internet banking
75. capital markets
76. FII's and India
77. failure of mutual funds
78. comparative study of mutual funds
79. emotional intelligence
80. organization culture in Indian organization
81. conflict management
82. time management
83. interpersonal relations
84. professional stress
85. performance appraisals
86. performance 360 appraisals
87. counseling
88. transactional analysis
89. organizational development
90. motivation
91. group dynamics
92. Vedic management
93. human relations
94. VRS
95. retrenchment
96. layoffs
97. training and development
98. recruitment in Indian organization
99. rural marketing
100. CRM
101. customer retention
102. management of services
103. customer behaviour with product
104. FEMA
105. tele marketing
106. sky shops
107. net work marketing
108. global marketing
109. industrial goods marketing
110. marketing mix case study
111. promotional strategies
112. exchange offers
113. after sales service
114. celebrity marketing
115. PLC
116. role of advertising
117. product diversification
118. product modification
119. product elimination
120. trend in privatization
121. trend analysis in FDI (sector wise / state wise)
122. impact of globalization in any specific industry
123. essentials of a valid contract
124. rights and duties of directors
125. xxxxxxxxxxxxxxxxxxx
126. futures and options
127. financial swaps
128. foreign exchange rates
129. creation of corporate entity
130. dishonour of cheques and liability of directors
131. prospectus for issue of capital
132. role of partners including implied authorities
133. effect of dissolution of partnership
134. MODVAT
135. effect of indirect taxes on industries
136. value added tax
137. meeting and minutes in a company
138. environmental management
139. labour welfare measures under factories act
140. environmental protection measures
141. Stress Management
142. Brand Equity
143. IT management, IT insights
144. Finance Scams in india

Contents

[hide]

• 1 Essence of finance
• 2 Fundamental financial concepts

• 3 History of finance

• 4 Finance terms, by field

o 4.1 Accounting (financial record keeping)

o 4.2 Banking

o 4.3 Corporate finance

o 4.4 Investment management

o 4.5 Personal finance

o 4.6 Public finance

o 4.7 Insurance

o 4.8 Economics and finance

o 4.9 Mathematics and finance

 4.9.1 Time value of money

 4.9.2 Financial mathematics

 4.9.2.1 Mathematical tools

 4.9.2.2 Derivatives pricing

o 4.10 Constraint finance

o 4.11 Virtual finance

• 5 Financial markets

o 5.1 Market and instruments

o 5.2 Equity market

 5.2.1 Equity valuation

 5.2.2 Investment theory

o 5.3 Bond market

o 5.4 Money market

o 5.5 Commodity market

o 5.6 Derivatives market

 5.6.1 Forward markets and contracts

 5.6.2 Futures markets and contracts

 5.6.3 Option markets and contracts

 5.6.4 Swap markets and contracts

 5.6.5 Derivative markets by underlyings

 5.6.5.1 Equity derivatives


 5.6.5.2 Interest rate derivatives

 5.6.5.3 Credit derivatives

 5.6.5.4 Foreign exchange derivative

• 6 Financial regulation

o 6.1 Designations and accreditation

o 6.2 Fraud

o 6.3 Industry bodies

o 6.4 Regulatory bodies

 6.4.1 International

 6.4.2 European Union

 6.4.3 Regulatory bodies by country

 6.4.3.1 United Kingdom

 6.4.3.2 United States

o 6.5 United States legislation

• 7 Actuarial topics

• 8 Asset types

• 9 Raising capital

• 10 Valuation

o 10.1 Discounted cash flow valuation

o 10.2 Relative valuation

o 10.3 Contingent claim valuation

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