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Principles and Process

Principles and Processes of Capital Budgeting and Investment Evaluation

This document outlines the fundamental principles of capital budgeting, the process involved, and the different criteria used to evaluate investment opportunities.

1. IntroductionPrinciples of Capital Budgeting

Capital budgeting decisions are guided by several core principles:

  • Cash Flow Focus:
    • Decisions should be based on cash flows rather than accounting profits. Cash flows represent the actual movement of money, which is critical for investment analysis.
  • Time Value of Money:
    • Future cash flows should be discounted to their present value. A dollar today is worth more than a crucialdollar processin the future due to its earning potential.
  • Risk Consideration:
    • Future cash flows are inherently uncertain, and this risk must be considered in the evaluation. Risk adjustment is necessary to account for firmsuncertainty.
  • Objective of Maximization:
    • The ultimate goal of capital budgeting is to allocatemaximize theirshareholder financialwealth. resourcesInvestment todecisions variousshould investmentbe proposals.consistent with this objective.

2. Capital Budgeting Process

The capital budgeting process typically involves generating, evaluating, selecting, andthe following up on capital expenditure alternatives.

2. Kinds of Capital Budgeting Decisions

Firms typically encounter three main types of capital budgeting decisions:steps:

  1. Accept-RejectIdentification Decisionof Investment Opportunities:
    • This involves generating new investment ideas and identifying projects that align with the firm's goals.
  2. MutuallyEvaluation Exclusiveof ChoiceRelevant DecisionCash Flows & Terminal Value:
    • This step requires estimating the cash inflows and outflows associated with each investment opportunity. It is important to focus on incremental, after-tax cash flows and consider the terminal value of the investment.
  3. CapitalSelection Rationingof Decisionan Investment Based on Evaluation Techniques:
    • This step utilizes a variety of techniques, including both discounted and non-discounted cash flow methods, to evaluate the viability of potential investments and make informed choices.
  4. Implementation of the Investment:
    • Once a project has been selected, this involves taking the necessary steps to implement the project.
  5. Monitoring and Review of Performance:
    • This involves tracking the performance of a project against the original projections, and making any necessary adjustments.

3. Investment Evaluation Criteria

2.3.1. Accept-RejectThree DecisionSteps of Investment Evaluation

The evaluation of an investment involves three crucial steps:

  1. Estimation of Cash Flows:
    • Calculating Fundamentalthe Decision:relevant Thiscash isflows, aincluding basicboth decisioninflows regardingand whetheroutflows.
      • to
    invest in a particular project or not.
  2. AcceptanceEstimation Criteria:of the Required Rate of Return: Projects
      that
    • Determining yieldthe aopportunity cost of capital, which is the minimum rate of return greateran thaninvestment themust requiredachieve rateto ofbe returnconsidered (orworthwhile.
      • the
    cost of capital) are generally accepted.
  3. RejectionApplication Criteria:of a Decision Rule: Projects
      that
    • Using doa notspecific meetdecision thisrule minimumor returntechnique thresholdto areanalyze rejected.the estimated cash flows and make a choice.

3.2. Essential Properties of a Sound Evaluation Technique

A sound appraisal technique for investment projects should:

  • Maximize Shareholder Wealth: The technique should align with the overall goal of increasing shareholder value.
  • IndependentConsider ProjectsAll Cash Flows:: UnderIt thismust decision,take into account all independentrelevant cash flows to determine the true profitability of a project.
  • Provide Objectivity: It should offer a clear, objective, and unambiguous way to distinguish between good and bad projects.
  • Enable Project Ranking: It must aid in ranking projects thatbased meeton their true profitability.
  • Recognize Time Value of Money: The technique should prioritize larger and earlier cash flows over smaller and later ones.
  • Choose Among Mutually Exclusive Projects: It should help to choose the criteria are implemented. Independent projects are thoseproject that don'twill competemaximize withshareholder onevalue another;from acceptinga onegroup doesn'tof precludemutually acceptingexclusive projects.
  • Apply to All Projects: The technique should be applicable to any investment project, independent of others.

2.2.3.3. MutuallyCategories Exclusiveof ProjectEvaluation DecisionsCriteria

Investment criteria are typically grouped into two main categories:

  1. Discounted Cash Flow (DCF) Criteria:
    • CompetitiveNet Projects:Present Value (NPV): MutuallyCalculates exclusivethe projectspresent arevalue thoseof thatall competecash flows associated with eacha other, meaning the acceptance of one automatically excludes the others.project.
    • ChoiceInternal Rate of One:Return (IRR): OnlyCalculates onethe discount rate at which the net present value of a project equals zero.
    • Profitability Index (PI): Measures the ratio of the competingpresent projects can be chosen.
    • Example: Selecting one outvalue of severalfuture competingcash brands of machineryflows to purchase.
    • Combined Decision: These decisions are not independent of accept-reject decisions. The projects considered must also be acceptable under the accept-rejectinitial criterion.
      • If no project is acceptable in accept-reject decision, then no mutually exclusive projects should be chosen.
      • If multiple mutually exclusive projects are acceptable, a specific technique is used to choose the "best" project from these. The selection of the best project automatically eliminates the other alternatives.investment.

  2. 2.3.Non-discounted CapitalCash RationingFlow Decision

    Criteria:
    • LimitedPayback Funds:Period (PB): InDetermines reality,how firmslong rarelyit havetakes unlimitedfor funds;an theyinvestment usuallyto havegenerate aenough fixedcash capitalto budget.recover its initial cost.
    • CompetitionDiscounted forPayback Funds:Period: ASimilar largeto numberthe payback period but considers the time value of investmentmoney proposalsby competeusing fordiscounted thesecash limited resources.flows.
    • AllocationAccounting Rate of Funds:Return (ARR): FirmsCalculates mustthe allocateaverage fundsaccounting profit relative to projects in a way that maximizes long-run returns.
    • Selection from Acceptable Projects: Capital rationing deals with selecting the bestinitial projects from a set of proposals deemed acceptable under the accept-reject decision.
    • Ranking: Capital rationing employs ranking of the acceptable investment projects based on a predetermined criterion such as the rate of return. The projects are ranked in descending order of rate of return.investment.

3.4. Key Terminology

  • Accept-Reject Decision: The processImportance of evaluatingNet whetherPresent aValue capital(NPV) expenditure

    The proposaldocument meetsmentions that the minimumnet criteriapresent value (NPV) criterion is considered the most valid technique for acceptance.

    • evaluating
  • an Mutuallyinvestment Exclusiveproject Projectsbecause (Decisions):it Projectsis that competeconsistent with one another; accepting one eliminates the others from consideration.
  • Capital Rationing: A financial situation where a firm has a fixed amount to allocate among competing capital expenditures.
  • Capital Budgeting Process: The four interrelated stepsobjective of evaluatingmaximizing andshareholder selecting long-term proposals: generation, evaluation, selection, and follow-up.
  • Independent Projects: Projects whose cash flows are unrelated; the acceptance of one does not eliminate others from consideration.
  • Unlimited Funds: The situation in which a firm can accept all independent projects that provide an acceptable return, which is rare in reality.
wealth.

4. Conclusion

Capital budgeting involvesis nota onlyvital evaluatingprocess individual projects but alsofor making choicesstrategic betweeninvestment competingdecisions. projectsBy adhering to sound principles, following a structured process, and allocatingusing limitedeffective evaluation criteria, organizations can allocate resources effectively.efficiently, Themanage accept-reject, mutually exclusive,risk, and capitalincrease rationingshareholder decisionsvalue. areWhile corea aspectsvariety of thismethods processexist, thatthe firmsNPV mustcriterion navigateis considered to optimizebe theirone financialof strategies.the most valid because it aligns directly with the objective of maximizing shareholder wealth.

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