financial institutions and markets, Study Guides, Projects, Research of Economics

Download financial institutions and markets and more Study Guides, Projects, Research Economics in PDF only on Docsity! Page 1 of 4 Capital Budgeting Techniques Capital budgeting: is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth. Capital expenditure: is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. Operating expenditure: is an outlay of funds by the firm resulting in benefits received within 1 year. Independent VS Mutually Exclusive Projects  Independent projects are projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration.  Mutually exclusive projects are projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function. Unlimited Funds VS Capital Rationing  Unlimited funds: is the financial situation in which a firm is able to accept all independent projects that provide an acceptable return.  Capital rationing is the financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for these dollars. Accept-Reject VS Ranking Approaches  An accept–reject approach is the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion.  A ranking approach is the ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return. Page 2 of 4 Example: Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. Payback Period The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows. The length of the maximum acceptable payback period is determined by management.  If the payback period is less than the maximum acceptable payback period, accept the project.  If the payback period is greater than the maximum acceptable payback period, reject the project. We can calculate the payback period for Bennett Company’s projects A and B:  For project A, which is an annuity, the payback period is 3.0 years ($42,000 initial investment ÷ $14,000 annual cash inflow).  Because project B generates a mixed stream of cash inflows, the calculation of its payback period is not as clear-cut. In year 1, the firm will recover $28,000 of its $45,000 initial investment. By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year 2) will have been recovered. At the end of year 3, $50,000 will have been recovered. Only 50% of the year-3 cash inflow of $10,000 is needed to complete the payback of the initial $45,000. The payback period for project B is therefore 2.5 years (2 years + 50% of year 3).