I’m gonna explain to you, the basic concepts of capital budgeting. The Capital Budgeting Decision
Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment
opportunities. Let say, now you have $1m, and three potential investments are being presented
to you. The process of deciding which project to invest is what we call capital budgeting. Capital budgeting has got a few indicators, such as payback period, NPV and IRR. These are to assist us to select the best investment for the company.
Through the analysis of potential additions to fixed assets, here it is important to note the
keywords fixed assets. Capital budgeting involves the consideration of investments in fixed assets, such as purchasing machines or equipment. It seeks to identify investments that will
enhance a firm’s competitive advantage and increase shareholder wealth. Investing in fixed assets is indeed a strategy to improve a firm’s competitive advantage. Competitive advantage is an attribute that enables a company to perform better than its competitors. To increase shareholder wealth is the same as to increase the share price or the value of the company. It is in line with the goal of shareholder wealth maximization.
Capital budgeting deals with long-term decisions which involves large expenditures. For committing a large sum of spending, the company has to be very cautious.
For the calculation, two parts we are gonna deal with. First, we have to estimate the amount of initial investment. Second,
the future cash inflows that could be received, that’s what we call cost and benefits analysis. Steps To Capital Budgeting
Next, the capital budgeting process consists of five steps.
First, estimate cash inflows and outflows.
Second, assess the riskiness of cashflows.
Third, determine the appropriate cost of capital, WACC.
Fourth, find the NPV and/or IRR.
Lastly, accept the investment if the NPV is greater than 0,
and/or the IRR is greater than the WACC.
We will explain more later in the following slides. Basic Terminology: Independent vs Mutually Exclusive Projects
Before showing you the calculation part, it’s essential to explain some basic terminology. First and foremost, let’s distinguish between
independent projects and mutually exclusive projects.
For independent projects, the acceptance of an
investment does not preclude the acceptance of other investments. In other words, accepting one project will not affect the decision of accepting another project.
It’s because the two projects do not compete for the firm’s resources. As long as the investments meet the relevant capital budgeting criterion,
all investments could be accepted.
However, for mutually exclusive projects, the acceptance of an investment would automatically
lead to rejection of other investments. Let say you have two potential projects
that are mutually exclusive, then you can only choose to accept one out of the two projects.
Mutually exclusive projects are the investments that compete in some way for
a company’s resources. In other words, due to the capital constraints of the company,
such projects cannot be undertaken simultaneously.
Therefore, only one investment could be undertaken at a particular time. Basic Terminology: Unlimited Funds vs Capital Rationing
Another comparison is between unlimited funds and capital rationing.
If the firm has unlimited funds for making investments, then all independent
projects that provide returns greater than some specified level can be accepted and implemented. But, unlimited funds is something that’s not realistic. It’s impossible that the company may have unlimited funds, no matter how big the company is.
That’s why in most cases, firms face capital rationing restrictions since they only have
a limited amount of funds to invest in potential investment projects at any given point of time. Limited amount of funds is the capital constraint. In short, capital rationing is the
act of placing restrictions on the amount of new investments or projects undertaken by a company.
Basic Terminology: Accept-Reject vs Ranking Approaches
Next, accept-reject approach vs ranking approach.
The accept-reject approach involves the evaluation of capital expenditure
proposals to determine whether they meet the firm’s minimum acceptance criteria. Projects will be evaluated one-by-one separately during the selection process.
However, the ranking approach involves the ranking of capital expenditures
on the basis of some predetermined measure, such as the rate of return. All the project’s returns will be ranked from the highest to the lowest. Basic Terminology: Conventional vs Nonconventional Cash Flows
Next, conventional cashflow vs nonconventional cashflow.
Conventional cash flows are cash flows which contain one cash outflow in the initial stage
then followed by a series of cash inflows. the sign only c
