Capital Budgeting Definition and Process

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Corporate Finance FIN 622

Lesson 08

CAPITAL BUDGETING

The following topics will be discussed in this hand out.

Fundamental Analysis

Capital Budgeting Definition and Process

Relevant costs

Non-relevant cost

Fundamental Analysis:

Fundamental Analysis is a security or stock valuation method that uses financial and economic analysis to

evaluate businesses or to predict the movement of security prices such as stock prices or bond prices. The

fundamental information that is analyzed can include a company's financial reports, and non-financial

information such as estimates of the growth of demand for competing products, industry comparisons,

analysis of the effects of new regulations or demographic changes, and economy-wide changes. It is

commonly contrasted with so-called technical analysis which analyzes security price movements without

reference to factors outside of the market itself.

A potential (or current) investor uses fundamental analysis to examine a company's financial results, its

operations and the market(s) in which the company is competing to understand the stability and growth

potential of that company. Company factors to consider might include dividends paid, the way a company

manages its cash, the amount of debt a company has, and the growth of a company's revenues, expenses

and earnings. A fundamental analyst may enter long or short positions based on the result of fundamental

analysis.

Three step process:

In large organizations fundamental analysis is usually performed in three steps:

· Analysis of the macroeconomic situation, usually including both international and national economic

indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy

prices.

· Industry analysis of total sales, price levels, the effects of competing products, foreign competition, and

entry or exit from the industry.

· Individual firm analysis of unit sales, prices, new products, earnings, and the possibilities of new debt or

equity issues.

Often the procedure stresses the effects of the overall economic situation on industry and firm analysis and

is known as top down analysis. If instead the procedure stresses firm analysis and uses it to build its industry

analysis, which it uses to build its macroeconomic analysis, it is known as bottom up analysis.

Criticisms:

· Some economists such as Burton Malkiel suggest that neither fundamental analysis nor technical

analysis is useful in outperforming the markets.

Capital budgeting:

Capital Budgeting is the planning process used to determine a firm's long term investments such as new

machinery, replacement machinery, new plants, new products, and research and development projects.

Capital budgeting process is carried out for projects involving heavy initial upfront cost.

These projects can take any of the following forms:

New project

Expansion project

Modernization / Replacement

Research & development

Exploration

Other / social responsibility Pollution control etc.

Corporate Finance FIN 622

Capital Budgeting Process:

Investment Opportunity (ies) is/are identified.

Different alternatives are considered.

Every alternative is evaluated

The best option(s) are undertaken

Many formal methods are used in capital budgeting, including discounted cash flow techniques such as net

present value, internal rate of return, Modified Internal Rate of Return and equivalent annuity method,

using 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.

Capital budgeting versus current expenditures:

frA capital investment project can be distinguished from current expenditures by two features:

a) Such projects are relatively large

b) A significant period of time (more than one year) elapses between the investment outlay and the receipt

of the benefits..

As a result, most medium-sized and large organizations have developed special procedures and methods for

dealing with these decisions. A systematic approach to capital budgeting implies:

a) The formulation of long-term goals

b) The creative search for and identification of new investment opportunities

c) Classification of projects and recognition of economically and/or statistically dependent proposals

d) The estimation and forecasting of current and future cash flows

e) A suitable administrative framework capable of transferring the required information to the decision level

f) The controlling of expenditures and careful monitoring of crucial aspects of project execution

g) A set of decision rules which can differentiate acceptable from unacceptable alternatives is required.

The last point (g) is crucial and this is the subject of later sections of the chapter.

The classification of investment projects

a) By project size

Small projects may be approved by departmental managers. More careful analysis and Board of Directors'

approval is needed for large projects of, say, half a million dollars or more.

b) By type of benefit to the firm

· an increase in cash flow

· a decrease in risk

· an indirect benefit (showers for workers, etc).

c) By degree of dependence

· Mutually exclusive projects (can execute project A or B, but not both)

· Complementary projects: taking project A increases the cash flow of project B.

· Substitute projects: taking project A decreases the cash flow of project B.

d) By degree of statistical dependence

· Positive dependence

· Negative dependence

· Statistical independence.

e) By type of cash flow

· Conventional cash flow: only one change in the cash flow sign

e.g. -/++++ or +/----, etc

· Non-conventional cash flows: more than one change in the cash flow sign,

e.g. +/-/+++ or -/+/-/++++, etc.

Corporate Finance FIN 622

Relevant Costs:

These are costs that are relevant with respect to a particular decision. A relevant cost for a particular

decision is one that changes if an alternative course of action is taken. Relevant costs are also called

differential costs.

Making correct decisions is one of the most important tasks of a successful manager. Every decision

involves a choice between at least two alternatives. The decision process may be complicated by volumes

of data, irrelevant data, incomplete information, an unlimited array of alternatives, etc. The role of the

managerial accountant in this process is often that of a gatherer and summarizer of relevant information

rather than the ultimate decision maker.

The costs and benefits of the alternatives need to be compared and contrasted before making a decision.

The decision should be based only on RELEVANT information. Relevant information includes the

predicted future costs and revenues that differ among the alternatives. Any cost or benefit that does not

differ between alternatives is irrelevant and can be ignored in a decision. All future revenues and/or costs

that do not differ between the alternatives are irrelevant. Sunk costs (costs already irrevocably incurred) are

always irrelevant since they will be the same for any alternative.

To identify which costs are relevant in a particular situation, take this three step approach:

1. Eliminate sunk costs and committed costs

2. Eliminate costs and benefits that do not differ between alternatives

3. Compare the remaining costs and benefits that do differ between alternatives to make the proper

decision.

4. Take care of opportunity cost.

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