capital budgeting.ppt

CAPITAL BUDGETING
Dr. John G. Kooti
ia Southwestern State University
John G. Kooti
Should We Build this Plant?
What is Capital Budgeting?
Analysis of potential additions to fixed assets
Long-term decisions, involve large expenditures
Very important to firm’s future
John G. Kooti
Steps in Capital Budgeting
Estimate Cash Flows (Inflows/Outflows)
Assess Riskiness of Cash Flows (CFs)
Determine Cost of Capital --Required Rate of Return
Find NPV and/or IRR
Accept or Reject Based on Criteria
John G. Kooti
Projects
Mutually Exclusive Projects -- the acceptance of one preclude the other. Example: To get a product across a river, you can either build a bridge or transport by boat. If on project is accepted, the other is rejected.
Independent Projects: The acceptance of one does not affect the other.
John G. Kooti
Projects
Normal Project: Cost (negative cashflows) followed by a series of positive cash flows. There is only one change in sign, either from negative to positive or positive to negative.
Non-Normal Project: Two or more change in signs. mon: Cost (negative CFs), then a series of positive CFs, then Cost of closing project. Example: Nuclear plant, strip mine.
John G. Kooti
Payback Period
The number of years to recover a project’s cost or how long does it take to get our money back? 0 1 2 3
|----------------|---------------|----------------|| -100 10 60 80 Cum=-100 -90 -30 50 Payback Period = 2 + 30/80 = years
John G. Kooti
Payback Period
Example 2: 0 1 2 3 |--------------------|---------------|--------------|| -100 70 50 20 Cum=-100 -30 20 40 Payback Period = 1 + 30/50 = years
John G. Kooti
Pay back Strength and Weakness
Strengths:
It provides an indication of a project's risk and liquidity
Easy to calculate and understand
Weakness
It ignores the Time Value of Money
It ignores cash flows occurring after the payback period
John G. Kooti
Discounted Payback
Uses discounted rather than raw cash flows.
Discounted payback considers the ti