Capital Budgeting: Wealth Maximization through Long-term Investment Decisions, Summaries of Financial Management

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 What is investment

 Why do we need for investment Appraisal

 How to apply the investment appraisal techniques

 What are Advantages and disadvantages of different investment appraisal techniques

Financial Goal of a Firm:

Wealth Maximization

Investment Decisions Financing Decisions

Short-term Investments

(Working Capital)

Long-term Investment

(Capital Budgeting)

Dividend Payout Policy

Capital Structure

✓ It is the most significant financial activity of the firm

✓ It determines the core activities of the firm over a long term future

✓ It must be made carefully and rationally

 Wrong decisions could be costly

 Difficult and expensive to reverse

 Organisation objectives

✓ cash flows refer to the movement of funds in and out of a project

✓ cash flow management focuses on the timing of moving funds

✓ management of cash flow is of great importance to project managers, because it

determines success/failure of a project even if the project

➢ makes good technical progress and

➢ is on schedule

✓ timing of cash flows has also a significant influence on project costs and schedule

✓ projects suffering from poor cash flow ultimately incur additional costs and,

possibly, significant delays as well

✓ sometimes, however, even borrowing additional money or stopping work until funds

are received may not be viable options

✓ Cash flow patterns of a capital investment projects can be classified as

➢ conventional – consists of an initial outflow followed only by a series of inflows

➢ nonconventional – involves an initial outflow followed by a series of inflows

and outflows

Cash outflows

Cash inflows

Cash outflows

Cash inflows

1. Search for investment opportunities – varies among firms and industries
2. Estimate all cash flows for each project
3. Evaluate the cash flows: traditional/non-discounted vs. modern/discounted methods
4. Make the accept/reject decision

➢ independent projects – accept/reject decision for a project is not affected by the accept/reject

decisions of other projects

➢ mutually exclusive projects – selection of one alternative precludes selection of another

alternative

5. Periodically reevaluate past investment decisions

✓ decisions are based on cash flows rather accounting profit

➢ noncash charges e.g., depreciation are treated in terms of tax savings

➢ effects of interest expenses are treated in terms of tax savings

✓ timing of cash flows is crucial – time value of money

✓ cash flows are based on opportunity costs/incremental cash flows

✓ cash flows are analyzed on an after-tax basis

✓ financing costs are ignored – reflected in the required rate of return/discount rate

✓ ignore a sunk cost – cost that has already been incurred and cannot be changed by

future action

✓ consider externality – effect of an investment on other things besides the investment

itself e.g., effects on cash flows of other parts of a firm

✓ All cash flows considered?

✓ Time value of money considered?

✓ Risk-adjusted?

✓ Ability to rank projects?

✓ Indicates added value to the firm?

➢ modern/discounted cash flow methods (DCF)

❖ consider time value of money

❖ include NPV, profitability-index (benefit-cost ratio), IRR, and discounted

payback period

❖ each method requires estimating cash flows and their timing for each project

❑ after tax cash outflows (costs) and inflows (revenues/savings)

❖ each method requires estimating project’s risk to determine an appropriate

discount rate (opportunity cost of capital)

❖ main weakness of DCF methods is that some of the above data is difficult to

obtain

✓ Payback method – length of time it takes to repay the cost of initial investment

o one of the simplest ways of measuring an investment’s worth.

✓ selection criterion – select a project with a payback period

➢ less than a cutoff – independent project

➢ shorter than that of an alternative project – mutually exclusive projects

❑ The rule is to accept those projects that have a payback period less than the limit set by

the management.

Example 1

ABC Co is considering to purchase a new machine for Br. 360 , 000. The life of the

machine is 10 years. The machine will reduce annual costs by Br. 50 , 000.

Required:

a) Compute the payback period for the machine.

b) Would the company purchase the new machine if the maximum desired payback

period of the management is 8 years?

c) Would the company purchase the new machine if the useful life of the machine is 5

years instead of 10 years? Why?

Answers: a) 7 years, 2 months & 12 days, b) yes! , c) no!, the machine ends without recovering its cost

Example 2

ABC Co is considering to purchase a new

machine having a life of 6 years. The

investment and expected cash inflows

related to the machine are given below.

Required:

a) Compute the payback period of the machine.

b) Would the company purchase the new machine if the maximum desired payback

period of the management is 5 years?

Answers: a) 4 years & 8 months b) Yes!