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    1.+CFP - Study+Guide - v2.0 31

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    Jerlin Preethi

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    1.+CFP - Study+Guide - v2.0 31

    Uploaded by

    Jerlin Preethi
    6 views2 pages

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    1.+CFP_Study+Guide_v2.0 31

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    Copyright:

    © All Rights Reserved
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    6 views2 pages

    1.+CFP - Study+Guide - v2.0 31

    Uploaded by

    Jerlin Preethi

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 2

    CORPORATE FINANCE AND PLANNING

    Why Must Capital be Budgeted?

    Because money is always limited, companies must be careful to choose projects that
    are feasible and profitable. Firms use the projected cash flows to filter only those ideas
    that they deem most likely to grow into money-making or money-saving projects. If
    there are alternatives and only one can be selected, the firm must identify and accept
    the most beneficial among all the projects.

    Capital budgeting is concerned with making the best investment choices and is the
    heart of corporate finance. We will study several different models that can help a
    company determine whether it should accept or reject a project. A “project” can be
    anything from a new machine to a new factory. We apply decision-making criteria to
    answer the question, “Is it worthwhile?”

    What Criteria Should We Use For Making Decisions?

    While it may not be possible to find an evaluation technique that perfectly meets all
    the criteria for decision making, we can find which one most closely meets it. To do
    so, lets understand the various criteria.

    1) Cashflows
    - Does the method use accounting profits or cashflows? Accounting profits
    can be manipulated and is not as reliable as cashflows.

    - If it uses cashflows, does it consider all the cashflows? That will help it to
    evaluate the full life of the project.

    2) Time Value of Money


    - Since $1 now is worth more than $1 later, is Time Value of Money
    considered when evaluating such long term projects?

    3) Risk-adjusted
    - Since every project may have different risk, is the method capable of
    factoring the different risks in each project?

    4) Ranking of Projects
    - Will this method be able to rank projects of varying sizes, allowing us to
    identify which is the best one?

    5) Value Added to the Firm


    - Will this method be able to show the value added to the firm, upon
    acceptance of the project?

    KHE-LCD-SGD-00250 39
    CORPORATE FINANCE AND PLANNING

    In the workplace, there are 4 general decision models that meet the above criteria in
    differing degrees.
    We will look at four decision models:
    • Net present value (NPV)
    • Payback period
    • Profitability index (PI)
    • Internal rate of return (IRR)

    Thereafter, we will weigh the valuation techniques by considering the advantages and
    disadvantages of each model.

    Net Present Value


    An investment is worth undertaking if it creates value for its owners. We create value
    by identifying an investment that is worth more than it costs us to acquire.

    Net Present Value (NPV) is the difference between the investment’s market value and
    its cost.

    We use the discounted cash flow valuation to find out the NPV of an investment. The
    discounted cash flow valuation is the process of valuing an investment by discounting
    its future cash flows.

    NPV of an investment is the present value of all benefits (cash inflows) minus the
    present value of all costs (cash out flows).

    NPV = PV of all benefits – PV of all costs


    The steps in an NPV calculation are
    Step 1: Estimate the expected future cash flows.
    Step 2: Estimate the required return for projects of this risk level.
    Step 3: Find the present value of the cash flows and subtract the initial investment to
    arrive at the Net Present Value.

    NPV is represented in a formula with the following:

    KHE-LCD-SGD-00250 40

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