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MC9901C03 Lecture Notes - Lecture 1: Capital Budgeting, Net Present Value, Project A

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anujacob091
2 Mar 2022
School
Mahatma Gandhi University - Kerala
Department
Finance
Course
MC9901C03
Professor

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Document Summary

In this article, you will learn what is capital budgeting, capital budgeting process and techniques of capital budgeting. Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholders" wealth. However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project. For example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are the business would have little chance of surviving in the competitive marketplace.

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Related Questions

PLEASE HELP WITH A RESPONSE TO THE POST BELOW. Thank you :)

  1. How do we traditionally define capital budgeting infinance?
  • Capital budgeting is a technique used in Finance by companiesto evaluate and rank the investment projects. These are the largeexpenditure projects including the purchase of plant and equipment,investment in new business, construction of buildings etc.
  1. What is the purpose of capital budgeting in the business firm,and how is it used?
  • Capital budgeting calculation involves cash flows withconversion into time value of money and arriving at a profit. Thereare several methods used for evaluating capital budgeting projects.Payback period method, Net present value method, internal rate ofreturn method and profitability index. All of these methods help amanager to analyze and select the projects based on profitabilityand returns. It is used to help the managers in arriving atinvestment decisions compared with the cost of capital. They alsogive the knowledge of time period within which cash outflows willbe returned. Large businesses rely on NPV and IRR to takeinvestment decisions. This technique provides a real return valuefor a business rather than just calculating the profits.Traditional accounting involves making decisions based on profitswithout considering the time value of money. Capital budgetingtechnique helps the manager to take decisions with present valuesof future returns.

Capital Budgeting and Dividend Policy.

Critically reflect on the importance of selecting the right projects in which to invest capital. Do we always select those projects that have the highest return on investment? What other factors play into capital budgeting decisions?

Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.

The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments

Cost

Cash Flow 1

Cash Flow 2

Project A

$ 50

$ -

$ 100

Project B

$ 50

$ 50

$ 25

According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.

This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?