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FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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Sixth Canadian Edition Lusztig, Cleary, Schwab CHAPTER TWELVE Capital Budgeting: Additional Topics Learning Objectives 1. Discuss why cash flows need to be projected ... – PowerPoint PPT presentation

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Title: FINANCE IN A CANADIAN SETTING Sixth Canadian Edition


1
FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition
  • Lusztig, Cleary, Schwab

2
  • CHAPTER TWELVE
  • Capital Budgeting Additional Topics

3
Learning Objectives
  • 1. Discuss why cash flows need to be projected
    in nominal terms when market discount rates are
    used.
  • 2. Explain what discount is used and why, when a
    business faces capital rationing.
  • 3. Explain why projects should be ranked
    according to their benefit-cost ratio.

4
Learning Objectives
  • 4. Discuss the additional considerations of
    international capital budgeting.
  • 5. Describe and define the relationship between
    capital budgeting, general corporate planning,
    strategic planning, and operating budgets.

5
Discounted Cash Flow Analysis and Inflation
  • The standard process of measuring inflation is
    called the current dollar discounting
  • Inflation influences two aspects of capital
    budgeting
  • 1. The general level of future cash flows
    generated by a project
  • 2. The cost of capital that is used as a
    discount rate

6
Discounted Cash Flow Analysis and Inflation
  • Forecasting the inflation rate over extended time
    periods is extremely difficult
  • Constant dollar discounting method is
    alternative method used to forecast the general
    level of inflation explicitly by removing the
    inflation component out of the cost of capital
  • Constant dollar discounting is used in the public
    sector but not in private sector project
    evaluation because there are interactions between
    the tax code and inflation

7
Project Interdependencies
  • Interdependencies occur when the cash flow
    generated from one project depends on other
    investments that the firm may consider
  • Extreme examples include
  • Mutually exclusive
  • Contingent projects
  • Generally the interdependence of projects may be
    either complementary or negative

8
Capital Rationing
  • Capital rationing when money has to be rationed
    among projects that compete for scarce funds
  • Under normal circumstances all positive NPV
    projects should be accepted
  • Project ranking based on NPV becomes the practice
    when firms face a capital constraint

9
International Aspects of Capital Budgeting
  • Large multinational firms view it as essential to
    be active in the major industrial areas of North
    America, Europe, and Asia-Pacific
  • Firms invest abroad to
  • minimize the cost of production
  • achieve economies of scale
  • circumvent trade barriers or regulations
  • exploit future opportunities

10
International Aspects of Capital Budgeting
  • Expected cash flows of international projects can
    be affected by
  • economic incentives
  • different tax rates and regulations
  • different business conduct
  • repatriation of profits
  • Factors affecting project risk in international
    projects include
  • political uncertainty
  • foreign exchange rates

11
International Aspects of Capital Budgeting
  • Factors affecting the discount rate in the
    international markets include
  • underdeveloped financial markets
  • favourable government financing offers
  • exchange rate risk

12
Organizational Issues
  • Investment planning is within general corporate
    planning
  • Capital budgeting has both a top down and a
    bottom up component
  • Approval of investment proposals proceeds in
    several stages depending on the type, size, and
    complexity of the proposal

13
Organizational Issues
  • Firms often group investment proposals into
    distinctive categories such as
  • 1. projects required by law
  • 2. safety and working condition
    improvements
  • 3. essential replacements and additions
  • 4. cost reduction and quality improvements
  • 5. capacity expansion for existing products
  • 6. new products or markets

14
Organizational Issues
  • Management is often faced with distortions from
    divisions and departments competing with each
    other for scarce corporate resources
  • Management can deal with distortions by
  • requesting additional information about the
    proposed project
  • systemic post-audits of projects
  • An approach to avoid competitive bidding for
    projects is for management to decentralize
    decision-making

15
Organizational Issues
  • There are two types of errors that can be made in
    investment decisions
  • accept a bad project (type 1 error)
  • reject a good project (type 2 error)
  • Trade-offs occur in trying to manage both types
    of errors

16
Summary
  • 1. Given inflation, it is important that in both
    the cash flow projections and choice of the
    discount rate, general price-level changes be
    reflected in a consistent manner.
  • 2. Interrelations between projects can become
    important in affecting diversification and risk.
    Any direct interdependencies between investments
    need to be recognized. In extreme cases, projects
    may be either mutually exclusive or contingent.

17
Summary
  • 3. When a firm faces capital rationing the
    discount rate to be used is the opportunity cost
    of funds, which equals the yield on the most
    attractive investment opportunity foregone.
  • 4. Projects should be ranked on the basis of
    their benefit-cost ratio, which equals the net
    present value per unit of capital invested. The
    larger ratios are the more attractive.

18
Summary
  • 5. International capital budgeting uses the same
    basic concepts and technologies, but added
    considerations affecting expected cash flows,
    risk, and the discount rate may exist.
  • 6. Capital budgeting is linked to both strategic
    planning and to operating budgets. Ultimately,
    positive net present values are only created when
    a firm can do things better or cheaper than its
    competitors.
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