Basic issues to pay attention to when learning Reading 32 in CFA level 1 program
1 Investment capital budgeting
Capital budgeting is the process by which a company makes decisions about capital projects – projects lasting one year or more.
Viewing: What is capital budgeting
1.1 Steps to planning investment capital budget
1.2 Classification of investment capital budgeting projects
Alternative projects to keep the business running
(replacement project to maintain the business)
Decide whether to maintain the operation and its operating procedures.
No detailed analysis is required.
Alternative project to reduce costs
(replacement project for cost reduction)
Decide whether to replace obsolete but still usable equipment with new equipment.
Relatively detailed analysis is required.
To develop business and need detailed study to forecast future demand.
Needs a very detailed analysis.
New products and services
(new products and services)
Involves many uncertain factors.
Detailed analysis is required.
Usually due to requests from government agencies, insurance companies, related safety or environmental issues.
Often no or low profit but facilitates other profitable projects.
Decide to implement the project or stop the related field activities so as not to have to carry out the project.
Difficult to analyze by conventional criteria.
2 Principles of capital budgeting
1. Decision based on cash flow, not on accounting profit
Incremental cash flows = Cash flow if the project is implemented – Cash flow if the project is not implemented. The extra cash flow involved in the decision-making process.
Sunk costs: costs that have occurred and do not change whether or not the project is implemented. Sunk costs are not relevant to the decision-making process.
Externality: the effect of the project implementation on other cash flows of the enterprise. Externalities are related to the decision-making process.
Positive externality: Project implementation has a positive effect on sales of other company products.
Negative externality/cannibalization: implementing a project that reduces sales of the company’s existing products.
Conventional cash flow: cash flows that change sign only once.
Conventional cash flow: cash flow that changes sign more than once.
2. Cash flow is based on opportunity cost
Opportunity costs: the cash flow that the company will lose if it undertakes this project.
For example, if carrying out a project to build a factory, the company should include the cost of land in the project cost, even if the land is owned by the company, because if the company does not build the factory, the company can profit from the sale of that land.
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The opportunity cost associated with the decision-making process.
3. The timing of cash flow is an important factor
Capital policy decisions take into account the time value of cash flows, so cash flows received first are more valuable than those received later.
4. Cash flow analyzed on an after-tax basis
The decision to undertake the project or not is concerned with the value of the company – the cash flow that the company will keep, regardless of the amount payable to the government. Therefore, tax should be considered in all decisions.
5. Financial costs are reflected in the required rate of return of the project
The discount rate in the capital planning analysis already includes the company’s cost of capital. Therefore, no financing costs are applied to any additional amounts. Only projects with an expected rate of return greater than the cost of capital will increase firm value.
The process of analyzing incremental cash flows is more complicated when it comes to project correlations.
Independent or mutually exclusive projects Independent projects are projects that are unrelated to each other and can be independently evaluated based on the profitability of each project. Example: If A and B are two independent projects and both bring profit to the company, the company can undertake both projects. Mutually exclusive projects where only one of the proposed projects can be approved and the projects compete with each other. Example: If A and B are mutually exclusive projects, the company can only undertake one of the two projects. Project sequencing: Some projects must be done in sequence, so that working on one project now opens the door to other projects in the future. Unlimited or limited capital If a company has unlimited funds, it can undertake all projects where the expected return is greater than the cost of capital. If the company only has a limited amount of capital and profitable investment opportunities require more than its available capital, the company needs to capital reasoning. Objective: maximize shareholder value with existing capital.
3 Investment decision criteria
Principles of decision making
The net present value
(net present value – NPV)
The sum of the present values of all expected incremental cash flows over the course of the project.
With independent projects:
NPV > 0: accept
NPV < 0: reject Internal rate of return (internal rate of return – IRR) The discount rate so that the present value of the expected after-tax cash flows is equal to the initial investment cost of the project. IRR > k: accept
IRR < k: reject where k is the required rate of return for the project Payback time (payback period - PBP) The number of years it takes to recoup the initial investment. Advantages: measure the liquidity of the project Limitation: does not take into account the time value of cash flows For a company with liquidity problems, the shorter the PBP, the better. However, decisions should not be made solely on the basis of PBP because of the stated limitation. Payback period with discount (discounted payback period) The number of years it takes to recover the initial investment, based on the present value of the cash flows. Discounted PBP > PBP.
Decisions should not be made based solely on this ratio as it only reflects the liquidity, not the profitability of the project.
(profitability index – PI)
The total present value of the cash flows divided by the initial investment
PI > 1 (NPV > 0): accept
PI < 1 (NPV < 0): reject NPV . graph (NPV profile) Graph showing the project's NPV at different discount rates
If following the IRR method, project 1 should be approved because IRR1 > IRR2.
When analyzing mutually exclusive projects, NPV is the optimal method.
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Therefore, project 2 should be approved.
The NPV method is a direct measure of the expected change in firm value when undertaking a capital project. In theory, a project with a positive NPV should increase the value of the company’s stock by the same amount. In practice, however, changes in stock prices often come from changes in the firm’s expectations for positive NPV projects.