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Lecture Fundamentals of finance management (10/E) - Chapter 10: The basics of capital budgeting

Lecture "Fundamentals of finance management - Chapter 10: The basics of capital budgeting" has contents: Steps to capital budgeting, calculating payback, strengths and weaknesses of payback, discounted payback period, financial calculator solution,.and other contents. | CHAPTER 10 The Basics of Capital Budgeting 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. Steps to capital budgeting Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC. What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other. What is the difference between normal and nonnormal cash flow streams? Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc. What is the payback period? The number of years required to recover a project’s cost, or “How long does it take to get our money back?” Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. Calculating payback PaybackL = 2 + / = 2.375 years CFt -100 10 60 100 Cumulative -100 -90 0 50 0 1 2 3 = 2.4 30 80 80 -30 Project L PaybackS = 1 + / = 1.6 years CFt -100 70 100 20 Cumulative -100 0 20 40 0 1 2 3 = 1.6 30 50 50 -30 Project S Strengths and weaknesses of payback Strengths Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback period. Discounted payback period Uses discounted cash flows rather than raw CFs. Disc PaybackL = 2 + / = 2.7 years CFt -100 10 60 80 Cumulative -100 -90.91 18.79 0 1 2 3 = 2.7 60.11 -41.32 PV of CFt -100 9.09 | CHAPTER 10 The Basics of Capital Budgeting 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. Steps to capital budgeting Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC. What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other. What is the difference between normal and nonnormal cash flow streams? Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of .