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Reading 34 – Corporate Governance and ESG: An introduction (*)
Reading 35 – Capital Budgeting (***)
Reading 36 – Cost of Capital (***)
Reading 37 – Measure of Leverage (**)
Reading 38 – Working Capital Management (**)
Capital Budgeting
Definition
The capital budgeting process is the process of identifying and
evaluating capital projects, that is, projects where the cash flow to the
firm will be received over a period longer than a year.
Four steps
1. Idea Generation
2. Analyzing project proposals
3. Create firm-wide capital budget
4. Monitor decision and post audit
Study Session 10 – Corporate Finance 1 Reading 35 – Capital Budgeting
Types of capital budget projects
5 types of capital budget projects
1. Replacement project
A. Mandatory projects
B. Cost reduction (Require detailed analysis)
2. Expansion project (Require detailed analysis)
3. Mandatory projects by regulatory projects
4. Other projects (e.g. Research, pet projects)
A. 6,800,000
B. 4,800,000
C. 3,800,000
IRR=22.91%
Study Session 10 – Corporate Finance 10 Reading 35 – Capital Budgeting
2 – Internal rate of return (IRR)
2) Problems with IRR
Conventional Cashflow – cash flow pattern that the sign of cashflow
changes only once
Unconventional Cashflow – cash flow pattern that the sign of cash
flows changes more than once
No IRRs or more than 1 IRR is found (neither are the answer)
(cannot use IRR method)
500,000
PBP = 2 + = 2.333 𝑦𝑒𝑎𝑟𝑠
1,500,000
Study Session 10 – Corporate Finance 13 Reading 35 – Capital Budgeting
4 – Discounted Payback period
4) Discounted Payback period
Discount Payback period use the present values of the project’s estimated cash
flows
Discounted PBP = A +B/C;
A = last year with negative cumulative discounted cash flow,
B = absolute value of the gap between 0 and last year with negative discounted
cash flow
C = Full year discounted cash flow
469,947
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = 1 + = 1.313
1,500,000
200,000 800,000 1,500,000
Profitability Index = ( 1+𝐼𝑅𝑅
+
1+𝐼𝑅𝑅 2
+ 1+𝐼𝑅𝑅 3
) / 1,500,000 = 1.313
Mutually exclusive
Only one or more but not all projects in a set of possible projects can be accepted
and that the projects compete with each other due to
i) Capital Rationing
ii) Project Sequence
Result: NPV, IRR, PI give contradictory result. NPV is the key factor
Study Session 10 – Corporate Finance 18 Reading 35 – Capital Budgeting
Practice Question (3)
Which of the following statements about NPV and IRR is least
accurate?
A. For independent projects if the IRR is less than the cost of capital
not accept the project.
B. The NPV method assumes that all cash flows are reinvested at the
cost of capital.
C. For mutually exclusive projects you should use the IRR to rank and
select projects.
A. 2.8
B. 3.0
C. 3.2
A. 15%
B. 18%
C. 21%