capital budgeting

Examples of capital budgeting in the following topics:

• The Goals of Capital Budgeting

  • Capital Budgeting, as a part of budgeting, more specifically focuses on long-term investment, major capital and capital expenditures.
  • The main goals of capital budgeting involve:
  • The real value of capital budgeting is to rank projects.
  • The highest ranking projects should be implemented until the budgeted capital has been expended.
  • When a corporation determines its capital budget, it must acquire funds.

• Risks Involved in Capital Budgeting

  • The process of capital budgeting must take into account the different risks faced by corporations and their managers.
  • Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
  • There are numerous kinds of risks to be taken into account when considering capital budgeting including:
  • Identify the different risks that must be accounted for in the capital budgeting process

• Defining Capital Budgeting

  • Capital budgeting is the planning process used to determine which of an organization's long term investments are worth pursuing.
  • Capital budgeting, which is also called "investment appraisal," is the planning process used to determine which of an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
  • It is to budget for major capital investments or expenditures.
  • Many formal methods are used in capital budgeting, including the techniques as followed:
  • Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment.

• Defining the IRR

  • IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments; the higher IRR, the more desirable the project.
  • The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments.
  • A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital.
  • Explain how Internal Rate of Return is used in capital budgeting

• Other Considerations in Capital Budgeting

  • Traditional capital budgeting theory holds that investments should be made when the simple net present value (NPV) of an investment opportunity equals or exceeds zero.

• Approaches to Assessing Risk

  • There are numerous important and applicable approaches to assessing risk in capital budgeting.
  • One can say that in the realm of capital budgeting and corporate finance, both types of risk assessment are crucial.
  • Its impact can be on the very existence, the resources (human and capital), the products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the environment.
  • The probable increase in cost associated with a risk (cost variance due to risk, Rc where Rc = P*C = P*Cost Accrual Ratio*S = P*S*CAR): sorting on this value puts the highest risks to the budget first, which can raise concerns about schedule variance.
  • Risk can be assessed in a number of ways, and is a critical step in capital budgeting and planning, as well as project management.

• Advantages of the IRR Method

  • The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investment.
  • A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital.
  • In other words, an investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital.
  • Describe the advantages of using the internal rate of return over other types of capital budgeting methods

• The Marginal Cost of Capital

  • The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this amount increases with total capital.
  • The marginal cost of capital is calculated as being the cost of the last dollar of capital raised.
  • Generally we see that as more capital is raised, the marginal cost of capital rises .
  • The Marginal Cost of Capital is the cost of the last dollar of capital raised.
  • Describe how the cost of capital influences a company's capital budget

• Dividend Irrelevance Theory

  • Under perfect market conditions, stockholders would ultimately be indifferent between returns from dividends or returns from capital gains.
  • Dividend irrelevance follows from this capital structure irrelevance.
  • Under these frictionless perfect capital market assumptions, dividend irrelevance follows from the Modigliani-Miller theorem.
  • However, the total return from both dividends and capital gains to stockholders should be the same.
  • Merton Miller, one of the co-authors of the capital irrelevance theory which implied dividend irrelevance.

• Overview of the Role of Financial Manager

  • The financial manager is responsible for budgeting, projecting cash flows, and determining how to invest and finance projects.
  • The manager is responsible for managing the budget.
  • The development of a new product, for example, requires an investment of capital over time.
  • The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.