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Capital Budgeting > Introduction to Capital Budgeting
Introduction to Capital Budgeting • Defining Capital Budgeting • The Goals of Capital Budgeting • Accounting Flows and Cash Flows • Ranking Investment Proposals • Reinvestment Assumptions • Long-Term vs. Short-Term Financing
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Capital Budgeting > Introduction to Capital Budgeting
Defining Capital Budgeting • Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing. • Major methods for capital budgeting include Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis. • The IRR method will result in the same decision as the NPV method for nonmutually exclusive projects in an unconstrained environment; Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV.
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Capital Budgeting > Introduction to Capital Budgeting
The Goals of Capital Budgeting • Basically, the purpose of budgeting is to provide a forecast of revenues and expenditures and construct a model of how business might perform financially. • Capital Budgeting is most involved in ranking projects and raising funds when long-term investment is taken into account. • Capital budgeting is an important task as large sums of money are involved and a long-term investment, once made, can not be reversed without significant loss of invested capital.
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Capital Budgeting > Introduction to Capital Budgeting
Accounting Flows and Cash Flows • Accounting flows involve Journal entries, Ledger accounts and Balancing to present a business's financial position in an Income statement, a Balance sheet and a Cash flow statement. • Cash flow is the movement of money into or out of a business, project or financial product. • Statement of cash flows includes three parts: Operational cash flows, Investment cash flows and Financing cash flows.
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Capital Budgeting > Introduction to Capital Budgeting
Ranking Investment Proposals • The higher the NPV, the more attractive the investment proposal. • The higher a project's IRR, the more desirable it is to undertake the project. • As the value of the profitability index increases, so does the financial attractiveness of the proposed project. • Shorter payback periods are preferable to longer payback periods. • The higher the ARR, the more attractive the investment.
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Capital Budgeting > Introduction to Capital Budgeting
Reinvestment Assumptions • If trying to decide between alternative investments in order to maximize the value of the firm, the reinvestment rate would be a better choice. • NPV and PI assume reinvestment at the discount rate. • IRR assumes reinvestment at the internal rate of return.
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Capital Budgeting > Introduction to Capital Budgeting
Long-Term vs. Short-Term Financing • Management must match long-term financing or short-term financing mix to the assets being financed in terms of both timing and cash flow. • Long-term financing includes equity issued, Corporate bond, Capital notes and so on. • Short-term financing includes Commercial papers, Promissory notes, Asset-based loans, Repurchase agreements, letters of credit and so on.
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Capital Budgeting
Key terms • accounts receivable Accounts receivable also known as Debtors, is money owed to a business by its clients (customers) and shown on its balance sheet as an asset. • APT In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. • Call option A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. [1] The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price) • Common stock Common stock is a form of corporate equity ownership, a type of security. • Default risk Default risk, also known as credit risk, refers to the risk that a borrower will default on any type of debt by failing to make the obligatory payments. • discounted cash flow In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. • Modified Internal Rate of Return The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR. • Preferred Stock Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. • Swap In finance, a swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. • time value of money The time value of money is the value of money, figuring in a given amount of interest earned over a given amount of time. • Weighted average cost of capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. Free to share, print, make copies and changes. Get yours at www.boundless.com
Capital Budgeting
Capital Budeting Windows of opportunity come into play when budgeting for capital because they can provide opportunities for firms to maximize returns on investment.
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Capital Budgeting
Private Equity Private equity firms, such as NBGI, provide funds for companies unable or uninterested in obtaining funds publicly.
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Capital Budgeting
Reinvestment Reinvestment to expand business
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Capital Budgeting
Reinvestment Factor Describe how the reinvestment factors related to total return.
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Capital Budgeting
Financing To manage business often requires long-term and short-term financing.
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Capital Budgeting
Cash flow The movement of money into and out of a business, project or financial product.
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Capital Budgeting
NPV formula Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore, NPV is the sum of all terms.
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Capital Budgeting
Calculation of the MIRR MIRR is calculated as follows:
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Capital Budgeting
Goals of capital budgeting The main goal of capital budgeting is to rank projects.
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Capital Budgeting
Investment Proposal Choosing the best investment proposal for business
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Capital Budgeting
Accounting cycle The basic cycle from open period to close period.
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Capital Budgeting
Which of the following is a correct definition of a capital budgeting method? A) The internal rate of return is the discount rate that gives a net present value of zero. B) Equivalent annuity method essentially value projects as if they were risk bonds. C) Real option analysis is the ratio of payoff to investment of a proposed project. D) The profitability index is the time required for an investment to "repay" the original investment.
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Capital Budgeting
Which of the following is a correct definition of a capital budgeting method? A) The internal rate of return is the discount rate that gives a net present value of zero. B) Equivalent annuity method essentially value projects as if they were risk bonds. C) Real option analysis is the ratio of payoff to investment of a proposed project. D) The profitability index is the time required for an investment to "repay" the original investment.
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Capital Budgeting
Which of the following is a function of corporate capital budgeting? A) To rank projects by profitability.
B) To evaluate the performance of managers.
C) To encourage managers to consider problems before they arise.
D) All of these answers.
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Capital Budgeting
Which of the following is a function of corporate capital budgeting? A) To rank projects by profitability.
B) To evaluate the performance of managers.
C) To encourage managers to consider problems before they arise.
D) All of these answers.
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Capital Budgeting
Which of the following is the correct order of steps in a basic accounting flow? A) Analyze the transactions, make journal entries, make adjusting entries, prepare statements. B) Analyze the transactions, make journal entries, prepare statements, make adjusting entries. C) Make journal entries, analyze the transactions, make adjusting entries, prepare statements. D) Make journal entries, prepare statements, analyze the transactions, make adjusting entries.
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Capital Budgeting
Which of the following is the correct order of steps in a basic accounting flow? A) Analyze the transactions, make journal entries, make adjusting entries, prepare statements. B) Analyze the transactions, make journal entries, prepare statements, make adjusting entries. C) Make journal entries, analyze the transactions, make adjusting entries, prepare statements. D) Make journal entries, prepare statements, analyze the transactions, make adjusting entries.
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Capital Budgeting
A company is analyzing a variety of potential investments using different capital budgeting methods. Which of the following represents the most profitable choice based on the information provided? A) The company picks a project with an accounting rate of return 5% over one with an ARR of 3%. B) The company picks a project with a 5 year payback period over one with a 3 year payback period. C) The company picks a project with profitability index of 1.25 over a project with a PI of -.25.
D) The company picks a project with an NPV of $250,000 over one with an NPV of $300,000.
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Capital Budgeting
A company is analyzing a variety of potential investments using different capital budgeting methods. Which of the following represents the most profitable choice based on the information provided? A) The company picks a project with an accounting rate of return 5% over one with an ARR of 3%. B) The company picks a project with a 5 year payback period over one with a 3 year payback period. C) The company picks a project with profitability index of 1.25 over a project with a PI of -.25.
D) The company picks a project with an NPV of $250,000 over one with an NPV of $300,000.
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Capital Budgeting
A firm is trying to choose the most profitable project to invest in. Which of the following should be used as the company's discount rate? A) The company's profitability index.
B) The company's weighted average cost of capital.
C) The company's reinvestment rate.
D) The company's internal rate of return.
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Capital Budgeting
A firm is trying to choose the most profitable project to invest in. Which of the following should be used as the company's discount rate? A) The company's profitability index.
B) The company's weighted average cost of capital.
C) The company's reinvestment rate.
D) The company's internal rate of return.
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Capital Budgeting
A company needs to obtain short-term financing due to an unexpected event. Which of the following options should it NOT pursue to meet its financial needs? A) Issuing commercial paper.
B) Obtaining an asset-based loan.
C) Issuing corporate bonds.
D) Entering into a repurchase agreement.
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Capital Budgeting
A company needs to obtain short-term financing due to an unexpected event. Which of the following options should it NOT pursue to meet its financial needs? A) Issuing commercial paper.
B) Obtaining an asset-based loan.
C) Issuing corporate bonds.
D) Entering into a repurchase agreement.
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Capital Budgeting
Attribution • Wikipedia. "Budget." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Budget • Wikipedia. "Capital budgeting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_budgeting • Wikipedia. "Common stock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Common%20stock • Wikipedia. "Preferred Stock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Preferred%20Stock • Wikipedia. "Capital budgeting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_budgeting • Wikipedia. "Modified Internal Rate of Return." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Modified%20Internal%20Rate%20of%20Return • Wikipedia. "APT." CC BY-SA 3.0 http://en.wikipedia.org/wiki/APT • Wikipedia. "Profitability index." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Profitability_index • Wikipedia. "Payback period." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Payback_period • Wikipedia. "Payback period." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Payback_period • Wikibooks. "Accountancy/Introduction to Accountancy." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Accountancy/Introduction_to_Accountancy#Overview_of_the_accounting_cycle • College Cram. "Accounting Cycle Overview | Accounting: Accounting Cycle | College-Cram.com." CC BY http://www.collegecram.com/study/accounting/accounting-cycle/accounting-cycle-overview/ • Wikipedia. "Cash flow." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Cash_flow • Wikipedia. "Default risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Default%20risk • Wikipedia. "Internal rate of return." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Internal_rate_of_return • Wikipedia. "Payback period." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Payback_period • Wikipedia. "Net present value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Net_present_value Free to share, print, make copies and changes. Get yours at www.boundless.com
Capital Budgeting
• Wikipedia. "Net present value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Net_present_value • Wikipedia. "Accounting rate of return." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Accounting_rate_of_return • Wikipedia. "Profitability index." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Profitability_index • Wikipedia. "time value of money." CC BY-SA 3.0 http://en.wikipedia.org/wiki/time%20value%20of%20money • Wikipedia. "discounted cash flow." CC BY-SA 3.0 http://en.wikipedia.org/wiki/discounted%20cash%20flow • Wikipedia. "Net present value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Net_present_value • Wikipedia. "Dividend reinvestment plan." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Dividend_reinvestment_plan • Wikipedia. "Rate of return." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Rate_of_return • Wikipedia. "Internal rate of return." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Internal_rate_of_return • Wikipedia. "Profitability index." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Profitability_index • Wikipedia. "Weighted average cost of capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Weighted%20average%20cost%20of%20capital • Wikipedia. "Corporate finance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Corporate_finance#The_financing_decision • Wikipedia. "Corporate bond." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Corporate_bond • Wikipedia. "Asset-based loan." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Asset-based_loan • Wikipedia. "Promissory note." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Promissory_note • Wikipedia. "Money market." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Money_market • Wikipedia. "Capital note." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_note#Convertibles • Wikipedia. "Letter of credit." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Letter_of_credit • Wikipedia. "Asset-backed commercial paper." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Asset-backed_commercial_paper
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Capital Budgeting
• Wikipedia. "Commercial paper." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Commercial_paper • Wikipedia. "Call option." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Call%20option • Wikipedia. "accounts receivable." CC BY-SA 3.0 http://en.wikipedia.org/wiki/accounts%20receivable • Wikipedia. "Swap." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Swap
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