Learn concept of capital budgeting and its importance.docx

7/21/2019 Learn concept of capital budgeting and its importance.docx

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INSTITUTE OF BUSINESSMANAGEMENT

CAPITAL BUDGETING

Advanced Financial Management

Name : Prince Wamiq Rasheed

Student ID : 15708

Course : Advanced inancia! "ana#ement

Instructor : "uhammad A!i Shai$h


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Muhammad Zubair Jamal (15757)

Q Learn concept of capital budgeting and its iportance !di"culties in decision process#

The process o identi!ing" anal!#ing" and selecting investment pro$ects%hose ret&rns 'cash (o%s) are e*pected to e*tend +e!ond one !ear, An

investment proposal sho&ld +e $&dged in relation to %hether or not itprovides a ret&rn e-&al to" or greater than" that re-&ired +! investors

Q E$plain t%e siilarities bet&een capital budgeting and securit'e(aluation#

The .ec&rit! Eval&ation and Capital B&dgeting are similar as the! &sesimilar methodologies to di/erentiate +et%een the relative merits oidenti0ed sec&rities" or availa+le pro$ects, In +oth cases" the aim is toma*imi#e the %orth1val&e to the individ&al1compan! over a period otime, In .ec&rit! Eval&ation" the sec&rities sho&ld +e chosen to deliver

the ma*im&m increase in Net 2orth over a 0*ed time hori#on, In CapitalB&dgeting" the +est com+ination o pro$ects sho&ld +e chosen to deliverthe ma*im&m ret&rn on capital invested" over a 0*ed time hori#on,

Q List and classif' t%e (arious capital budgeting e(aluationtec%ni)ues * in(estent criteria#

3, Average 4ate o 4et&rn 'A44)5, Net Present 6al&e 'NP6)7, Internal 4ate o 4et&rn 'I44)8, Modi0ed Internal 4ate o 4et&rn 'MI44)

9, Pro0ta+ilit! Inde* 'PI):, 4eg&lar Pa!+ac;saet! margin,?

Q E$plain t%e rationale of t%e N+, rule#

The net present val&e 'NP6) is de0ned as the present val&e o a pro$ect=scash in(o%s min&s the present val&e o its costs, It tells &s ho% m&ch thepro$ect contri+&tes to shareholder %ealth, The larger the NP6" the moreval&e the pro$ect adds and th&s the higher the stoc;=s price, NP6 isgenerall! regarded as the +est single screening criterion,

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Beore &sing NP6 in the decision process" %e need to ;no% %hetherPro$ects in consideration are independent or m&t&all! e*cl&sive,Independent pro$ects are those %hose cash (o%s are not a/ected +!other pro$ects, M&t&all! e*cl&sive pro$ects" on the other hand" are t%odi/erent %a!s o accomplishing the same res&lt" so i one pro$ect is

accepted then the other m&st +e re$ected,

For independent pro$ects" i NP6 e*ceeds #ero" accept the pro$ect, Form&t&all! e*cl&sive pro$ects" accept the pro$ect %ith the highest positiveNP6, I no pro$ect has a positive NP6" then re$ect them all,

Q /iscuss t%e probles associated &it% I00#

2ith the I44 method" the disadvantage is that" at times" it can give !o&con(icting ans%ers %hen compared to NP6,For e*ample Pro$ect A calls or investing 4s, 3@@"@@@ and then receiving

4s, 9@"@@@ per !ear or 3@ !ears" %hile Pro$ect B calls or investing 4s, 3and then receiving 4s, @,:@ per !ear or 3@ !ears, ere are the t%opro$ect=s NP6s and I44s

N+,A14s, 5@


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2e estimate a pro$ect=s cash (o%s 'CF) and then disco&nt them at thepro$ect=s ris;ad$&sted cost o capital" r" the res&lt is the pro$ect=s NP6"%hich tells &s ho% m&ch the pro$ect increases the 0rm=s val&e, nce apro$ect has +een accepted and placed in operation pro$ect cash (o%s are

added to the 0rm=s ree cash (o%s rom other so&rces, Thereore"pro$ects= cash (o%s essentiall! determine the 0rm=s ree cash and th&sorm the +asis or the 0rm=s mar;et val&e and stoc; price,

Q 5ustif' &%' cas%6 not incoe6 3o&s are t%e ost rele(ant tocapital budget decision#

Capital +&dgetingdecisions sho&ld +e +ased on cash (o%s that aread$&sted or the time val&e o mone!, The time val&e o mone!recogni#es that a dollar received or spent in the &t&re is less val&a+lethan a dollar received or spent in the present, Calc&lations s&ch as

the internal rate o ret&rnand net present val&eincl&de ad$&stments orthe time val&e o mone!,

Under accr&al acco&nting" reven&es and e*penses are reported +asedon acco&nting principles, This means that reven&es are reported %henthe! are earned" and e*penses are matched to the periods o thereven&e, In other %ords" reven&es and e*penses are not reported on theincome statement %hen the mone! is received or spent, F&rther" thereven&e and e*pense amo&nts are not ad$&sted or the time val&e omone! +eca&se o the monetar! &nit ass&mption,

Q /escribe a 7r8s capital structure#

The capital str&ct&re is ho% a 0rm 0nances its overall operations andgro%th +! &sing di/erent so&rces o &nds,Generall! term capital str&ct&re is &sed to reer to a 0rmHs de+ttoe-&it!ratio" %hich provides insight into ho% ris;! a compan! is,

Q /escribe t%e factors a9ecting t%e cost of capital#

The cost o capital is a/ected +! some actors that are &nder a 0rm=scontrol and some that are not,

T%ree Factors t%e Fir :annot :ontrolThree ;e! determinants o 2ACC are +e!ond a 0rm=s controli Stoc; and Bond Mar;ets The stoc; and +ond mar;ets" and the

mar;et or shortterm de+t" are normall! in e-&ili+ri&m and th&sairl! sta+le, o%ever" at times the mar;ets are disr&pted" ma;ing itvirt&all! impossi+le or a 0rm to raise capital at reasona+le rates,Note also that i interest rates in the econom! rise" the costs o +oth

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de+t and e-&it! %ill increase, The 0rm %ill have to pa! +ondholdersa higher interest rate to o+tain de+t capital, igher interest ratesalso increase the cost o e-&it!,

ii Mar;et 0is; +reiu Investors= aversion to ris; determines themar;et ris; premi&m, Individ&al 0rms have no control over the 4PM"

%hich a/ects the cost o e-&it! and th&s the 2ACC,iii Ta$ 0ates Ta* rates" %hich are in(&enced +! the government"have an important e/ect on the cost o capital, The! are &sed %hen%e calc&late the aterta* cost o de+t or &se in the 2ACC, Inaddition" the lo%er ta* rate on dividends and capital gains than oninterest income avors 0nancing %ith stoc; rather than +onds,

T%ree Factors t%e Fir :an :ontrol

A 0rm can a/ect its cost o capital thro&gh

i :apital Structure +olic'1A 0rm can change its capital str&ct&re"and s&ch a change can a/ect its cost o capital, For e*ample" theaterta* cost o de+t is lo%er than the cost o e-&it!" so i the 0rmdecides to &se more de+t and less common e-&it!" then thisincrease in de+t %ill tend to lo%er the 2ACC, o%ever" anincreased &se o de+t %ill increase the ris; o de+t and the e-&it!"o/setting to some e*tent the e/ect d&e to a greater %eighting ode+t,

ii /i(idend +olic' The percentage o earnings paid o&t in dividends

ma! a/ect a stoc;=s re-&ired rate o ret&rn, Also" i the pa!o&t ratiois so high that the 0rm m&st iss&e ne% stoc; to &nd its capital+&dget" then the res&lting (otation costs %ill also a/ect the 2ACC,

iii In(estent +olic'12hen %e estimate the cost o capital" %e &seas the starting point the re-&ired rates o ret&rn on the 0rm=so&tstanding stoc; and +onds" %hich re(ect the ris;s inherent in thee*isting assets, Thereore" %e are implicitl! ass&ming that ne%capital %ill +e invested in assets %ith the same degree o ris; ase*isting assets, This ass&mption is generall! correct" +eca&se most0rms do invest in assets similar to those the! c&rrentl! &se,o%ever" the e-&al ris; ass&mption is incorrect i a 0rm

dramaticall! changes its investment polic!, For e*ample" i acompan! invests in an entirel! ne% line o +&siness" then itsmarginal cost o capital sho&ld re(ect the ris; o that ne% +&siness,

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Learn concept of capital budgeting and its importance.docx