capital budgeting
Capital Budgeting Rules: NPV, IRR, Payback, Discounted Payback, AAR
Categories of Plans
1. Replacement Projects: decisions to replace old equipment – those are among the easier of capital budgeting techniques. It is important to decide whether to replace the equipment when it wears out or to invest in repairing the machine.
2. Expansion Projects: These are decisions whether to increase the size of business or not – they are more uncertain than replacement projects.
3. New products and services: These are decisions whether to introduce new products and services or not – they are more uncertain than both replacement and expansion projects.
4. Safety and environmental projects: These are the projects required by governmental agencies and insurance companies – these projects might not generate revenue and are not for profits; however, sometimes it is important to analyze the cash flows because the costs might be very high that they require analysis.
Basic Principles of Capital Budgeting
Capital budgeting usually uses the following assumptions:
1. Decisions are based on cash flows not income
2. Timing of cash flows is important
3. Cash flows are based on opportunity cost: cash flows that occur with an investment compared to what they would have been without the investment
4. Cash flows are analyzed on after-tax basis:
5. Financing costs are ignored because they are incorporated in WACC – that is why counting them twice would be considered double counting
Costs Concepts of Capital Budgeting
Some important capital budgeting concepts that managers find very useful are given below:
1. Sunk costs: costs that already incurred (i.e. paid for marketing research study) – Today costs should not be affected by sunk costs
2. Opportunity costs: what a resource is worth for next-best use – Those costs should be considered (i.e. if you use a warehouse, the current market value should be considered)
3. Incremental cash flow: the cash flow that is realized with the project – that is,
Categories of Plans
1. Replacement Projects: decisions to replace old equipment – those are among the easier of capital budgeting techniques. It is important to decide whether to replace the equipment when it wears out or to invest in repairing the machine.
2. Expansion Projects: These are decisions whether to increase the size of business or not – they are more uncertain than replacement projects.
3. New products and services: These are decisions whether to introduce new products and services or not – they are more uncertain than both replacement and expansion projects.
4. Safety and environmental projects: These are the projects required by governmental agencies and insurance companies – these projects might not generate revenue and are not for profits; however, sometimes it is important to analyze the cash flows because the costs might be very high that they require analysis.
Basic Principles of Capital Budgeting
Capital budgeting usually uses the following assumptions:
1. Decisions are based on cash flows not income
2. Timing of cash flows is important
3. Cash flows are based on opportunity cost: cash flows that occur with an investment compared to what they would have been without the investment
4. Cash flows are analyzed on after-tax basis:
5. Financing costs are ignored because they are incorporated in WACC – that is why counting them twice would be considered double counting
Costs Concepts of Capital Budgeting
Some important capital budgeting concepts that managers find very useful are given below:
1. Sunk costs: costs that already incurred (i.e. paid for marketing research study) – Today costs should not be affected by sunk costs
2. Opportunity costs: what a resource is worth for next-best use – Those costs should be considered (i.e. if you use a warehouse, the current market value should be considered)
3. Incremental cash flow: the cash flow that is realized with the project – that is,