Capital Budgeting And The Nature Of Capital Decisions Finance Essay

The Nature of Capital Expenditure Decisions. Decisions to replace assets have the effect of changing the different technologies being employed by the firm. This leads to an alteration of the relevant production and cost function. Most replacement decisions are made with expectations.

Decisions to expand a firm's asset base lead to an increase in the scale and size of the cost of productive facilities. Expansion decisions are based on forecasts of future demand, and costs after expansion. If quantity demanded is suitably high and costs sufficiently low, the resulting profits may justify the expansion decision.

A capital expenditure is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year. It is distinguished from a normal operating expenditure, which is expected to result in cash benefits during the coming one year period. Capital budgeting is the process of planning for and evaluating capital expenditures.

The importance of capital expenditures to a firm is derived from the fact of current outlay. These current outlays affect future profitability, and in aggregate they plot the future direction of the firm by determining products, markets to be entered, location of plants and facilities and the type of technology to be used. Capital expenditures require careful analysis because they are both costly and difficult to reverse without incurring considerable costs.

Cost Function

It is the relationship between cost and activity; being either linear or nonlinear. The general formula for a linear relationship is y = a + bx, where y is the estimated value of a cost item for any specified value of x (activity). The constant a, the intercept, is the fixed cost element; b, the slope, is the variable rate per unit of x. The possible measures of activity x include:

Units of product 2) Machine-hours

3) Dollar sales volume 4) Direct labor-hours

Basic Framework for Capital Budgeting Decisions

A firm should operate at the point where the marginal cost of an additional unit of output just equals the marginal revenue.

MC = MRFormula

MC Marginal Cost

MR Marginal Revenue

Marginal costs may be interpreted as the firm's weighted marginal cost of capital - the cost successive increments of capital acquired by the firm used in the firm's capital structure.

Capital Budgeting Process and Generating Capital Investment Projects

The process of selecting capital investment projects consists of:

Alternative capital investment project proposals

Cash flows for the project proposals

Alternatives available for the investment projects

Review of the investment projects

1.3.1 Generating Capital Investment Projects

Ideas for new capital investments can come from both inside and outside the firm from factory workers to board of directors. Most firms have staff groups whose responsibilities include searching for and analyzing capital expenditure projects. These staff groups include cost accounting, marketing research, research and development and corporate planning personnel.

Capital expenditure projects can be classified into various categories depending on the nature of benefits expected.

One category includes projects that are designed to reduced cost. Old plants and equipment have higher maintenance cost and should generate proposals to replace with new ones.

A second category includes projects designed to improve a firm's demand curve if the increased demand for product lines is forecast and distribution facilities are inadequate to meet the demands.

A third category includes those that create future growth options for the firm. Example: Investing in research and development creates future growth which gives the firm an option to bring a new product to market.

A fourth type of capital expenditure includes projects designed to meet legal requirements and health and safety standards like proposals for pollution control, ventilation, employees safety and fire-protection equipment.

1.4 Estimating Cash Flows

Investments projects, cash flows will occur in the future, in varying degrees of uncertainty.

Natural tendency is for some individuals to be overly optimistic in their estimates, to underestimate the costs and to overestimate the benefits of an investment project.

Certain basic guidelines have been found helpful in approaching the analysis of investment alternatives.

Cash flows should be measured on an incremental basis.

Cash-flow stream for the project to the firm,

After-tax basis

Indirect effects

Sunk costs should not be considered. A sunk cost is an outlay that has been made and cannot be recovered, they should not be considered in the decision to accept or reject a project.

Opportunity Costs is the value of a resource in its next best alternative. Capital budgeting, opportunity costs of resources, cash flows under consideration.

The incremental, after tax net cash flows, (NCF) investment project are equal to cash inflows minus cash outflows.

The life of the project, these may be defined as the difference in net income after tax (âˆ†NIAIT) with and with-out the project plus the depreciation (âˆ†D):

Cash Flow Formula's;

âˆ†NIBT = âˆ†R-âˆ†C-âˆ†D

âˆ†NIAT = âˆ†NIBT (1 - t)

NCF = âˆ†NIAT + âˆ†D

1.5 Evaluating the firm's cost of capital

Criteria can be employed to determine the desirability of investment projects. The section focuses on two widely used discounted cash-flow methods.

Internal Rate of Return (r) or (IRR)

Net Present Value (NPV)

Internal Rate of Return: The internal rate of return (IRR) is defined as the discount rate that equates the present value of the net cash flows from the project with the net investment.

NCFt = NINV (1+r)t

Formula-1

Net Present Value: The net present value (NPV) of an investment is defined as the present value, discounted at the firm's required rate of return (cost of capital).

NPV = NCFt - NINV

(1+k) t

Formula-2

1.6 Reviewing Investment Projects after Implementation

A very important but often neglected step in the selection process is the review of investment projects after they have been implemented. The purpose of this review should be to provide information on the effectiveness of the selection process.

The estimated cash flows at the time the project was proposed.

Cost and revenues.

The analysis should be concerned with checking for any large or systematic discrepancies.

Decisions makers to make better evaluations of investment proposals submitted in the future by comparing cost and NPV.

1.7 Estimating the firm's Cost of Capital

A firm's cost of capital is an important input in the capital-budgeting analysis procedure is a complex topic.

The cost of capital is concerned with what a firm has to pay for the capital, debt, preferred stock, retained earning's and common stock.

Firm's cost of capital is determined in the capital markets.

Degree of risk with new investments, existing assets, and the firm's capital structure.

The cost of capital can be thought of as the minimum rate of return required on new investments undertaken by the firm.

1.7.1 Cost of Debt Capital

V0 = I + M .

(1+ kd) (1 + kd)nFormula-1

kd Rate of return

I Interest

n Life of the project

M Principal repayment

V0 Offering price

Ki = kd (1 - t)Formula-2

Ki After tax

kd Pretax debt

t Firms marginal tax rate

V0 = Dt .

(1+ ke)tFormula-3

V0 Offering price