Week 4 Essay

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Pages: 12

Lectures so far…Weeks 1-3

FINS1613 Business Finance

 Firm’s objective = Maximise firm value

Lecture 4:

 How to measure firm value?


V  t 1

Capital Budgeting- An Introduction

Ct
1  r t

Core Reading: RTBWJ Chapter 8
Additional Readings: Graham & Harvey (2001)
Truong et al. (2008)

 Financial management decisions:– The Investment Decision
– The Financing Decision
– The Dividend Decision

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Lecture 4: Learning Objectives

What is capital budgeting?

 Capital budgeting is the process of analysing long-term

 Understand the importance of capital budgeting and

the steps in the process

investment projects that will generate cash flow and deciding:  Understand the types of projects a firm may wish to

undertake

– whether a particular project is acceptable, or

 Understand the decision rules for the main methods of

– which project to choose between a number of possible projects. projects project evaluation
 Understand the advantages & disadvantages of each of the main methods for project evaluation

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Capital Budgeting Process

4

Capital Budgeting Process (cont.)

3. Evaluation

1. Generate project proposals


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Does the project fit with the firm’s long-term goals? Quantitative Analysis
– Project worth > Project cost?
– Project j return > Project j required q return?

2. Screening:




How will the project affect the firm?


Type of project



Evaluating different options

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Qualitative Analysis

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1

Capital Budgeting Process

Capital Budgeting Process (cont.)



4. Implementation & Control


Amount of time spent by managers

Monitoring actual cash flows relative to forecasts

Stage

5 Post-implementation
5.
Post implementation Audit


How important is each stage?


Project follow-up and review

Time Spent(%)

gp proposals p
Generating

20.3

Screening

24.4

Evaluation

19.3

Implementation & Control

22.4

Audit

13.6

Source: Gitman and Maxwell (1985)_USA
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Screening: Type of Project

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Screening: Replacement

 Projects fall under four general categories:

 Maintenance of Existing Business

– Replacement
– Expansion

 Cost Reduction

– Safety & Environmental
– Other projects

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Screening: Expansion

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Screening: Safety & Environmental

 Existing Markets or Products

 Mandatory investments to ensure compliance with

 New Markets or Products

government legislation on safety or environmental issues.  The investment may or may not result in any positive cash h flows fl f the for th firm. fi  Projects of this type require analysis of how the firm will fund the investment and its impact on the firm.

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Screening: Evaluating options

Screening: Other Projects

One project

 Infrastructure developments, buildings etc. that do not

fall under one of the previous project classifications.

Accept

Reject

 Analysis of these projects is carried out using the best

approach for the specific project under consideration.

Multiple Projects
Independent

Mutually Exclusive
Contingent

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Screening: Independent Projects

flows.
 Each project is analysed independently and the decision to accept or reject will have no impact on whether another project is accepted or rejected. rejected  The firm could accept one or more projects or it could reject them all.

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Screening: Mutually Exclusive Projects (cont.)

 Projects in which accepting one project requires

rejecting all other options.
 Projects are analysed separately but need to be ranked

relative to each other in order to determine which to undertake. undertake
 Projects are mutually exclusive typically because of resource or financial constraints.

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Screening: Mutually Exclusive Projects (cont.)

 Example of Resource Limitation

 Example of…