Finance Project

Re: Finance Project : Capital Budgeting Nontes

Attache here Capital Bugeting Notes for Finance Project.
:SugarwareZ-256::SugarwareZ-288:

CAPITAL BUDGETING
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1]
Many formal methods are used in capital budgeting, including the techniques such as
• Net present value
• Profitability index
• Internal rate of return
• Modified Internal Rate of Return
• Equivalent annuity
These methods use the incremental cash flows from each potential investment, or project Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.
Contents
• 1 Net present value
• 2 Internal rate of return
• 3 Equivalent annuity method
• 4 Real options
• 5 Ranked Projects
• 6 External links and references

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.
In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV[citation needed], although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.
Equivalent annuity method
The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.
It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.
The use of the EAC method implies that the project will be replaced by an identical project.
Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers.
The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.
 
Finance report :
Capital investment decisions
Capital investment decisions [2] are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate. These projects must also be financed appropriately. If no such opportunities exist, maximizing shareholder value dictates that management return excess cash to shareholders. Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.
The investment decision
Main article: Capital budgeting
Management must allocate limited resources between competing opportunities ("projects") in a process known as capital budgeting [3]. Making this capital allocation decision requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows.
Project valuation
Further information: stock valuation and fundamental analysis
In general [4], each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. These future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV.
The NPV is greatly affected by the discount rate. Thus identifying the proper discount rate—the project "hurdle rate"—is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the financing mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI; see list of valuation topics.
Valuing flexibility
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open (or close) paths of action to the company, but this reality will not typically be captured in a strict NPV approach. [5] Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the “flexibile and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) [6] and Real options analysis (ROA) [7]; they may often be used interchangeably:
• DTA values flexibility by incorporating possible events (or states) and consequent management decisions. In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this “knowledge” of the events that could follow, management chooses the actions corresponding to the highest value path probability weighted; (3) then, assuming rational decision making, this path is taken as representative of project value. See Decision theory: Choice under uncertainty. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" - each scenario must be modelled separately.)
• ROA is usually used when the value of a project is contingent on the value of some other asset or underlying variable. Here, using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option - valuation is then via the Binomial model or, less often for this purpose, via Black Scholes; see Contingent claim valuation. The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.)
:SugarwareZ-229::SugarwareZ-064::nono:
 
You must log in or register to reply here.
Back
Top