finance 2

• Capital Budgeting


  The process of evaluating long-term investments
• Capital Budgeting Examples


  • Addition or replacement of a fixed asset, like machinery
  • Large-scale project, such as buying real estate or another company
• Capital Budgeting


  The process that a business uses in evaluating and selecting major projects or investments. It involves: capital investments proposal evaluation, allocation of capital investment funds among approved projects and programs, and control of such expenditures.
• Capital Expenditures


  Long-term investments
• Purpose of Capital Budgeting

  Analyzing, evaluating and prioritizing investment on capital-intensive projects to determine the best use of funds to increase the value of a business
• Steps in Capital Budgeting

  1. Identifying and generating projects

  2. Evaluating the projects

  3. Selecting a project (decision making)

  4. Implementing a project

  5. Review project performance
• Opportunity Cost


  The value of what you lose when you choose from two or more alternatives
• Independent Projects


  Do not compete with other projects
• Mutually Exclusive Projects


  Compete with other projects and the approval of one eliminates the other projects
• Terms related to Capital Budgeting

  • Exclusive Projects
  • Capital Rationing and Unlimited Funds
  • Cash Returns
• Payback Method


  Evaluates a project by measuring the time (usually expressed in years) it will take to recover the initial investments
• Net Present Value (NPV)

  The difference between the present value of cash inflows and the net present value of cash outflows over a period. If NPV is positive, the project or investment should be accepted. If it is negative, it means that it will result in a loss so it should be rejected.
• Internal Rate of Return (IRR)

  The discount rate that makes the net present value of an investment equals to zero
• Profitability Index


  A technique that calculates the cash return per dollar invested in a capital project. It is calculated by dividing the NPV of all the cash inflows by the NPV of all the outflows. Projects with an index less than 1 are typically rejected, while projects with an index greater than 1 are ranked and prioritized.
• Payback Method vs NPV/IRR/PI

  Payback doesn't rely on discounted cash flow technique, while NPV/IRR/PI are based on capitalization of cash flows/discounted cash flow technique
• Constraint Analysis


  A criterion used in capital budgeting to help select capital projects based on operational or market limitations. It looks at company processes and identifies bottlenecks - pinch points in the process that would make downstream investments of no use.