6.1 capital projects 6.2 capital budgeting process …myfinanceclass.com/files/101669450.pdf ·...

Business Finance© Thomson/South-Western

Chapter

Long-Term Financial Activities

6

6.1 CAPITAL PROJECTS 6.2 CAPITAL BUDGETING PROCESS 6.3 CAPITAL PROJECT ANALYSIS 6.4 BUSINESS EXPANSION STRATEGIES


Chapter 6Slide 2

Lesson 6.1

Capital Projects

GoalsDescribe types of capital projects used in business.Explain factors that affect capital spending decisions.


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Termscapital projectintellectual propertymutually exclusive projectscomplementary projects


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Capital Spending Activities

capital project (capital expenditures)the construction or purchase of a long-term asset

capital spendingthe process of spending money to pay for capital projects


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REPLACEMENT PROJECTFailure to replace items in a timely manner can result in

higher costslost salesreduced profits


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COST-SAVING PROJECT

New technology enables companies to purchase equipment that reduces operating costs.


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NEW PRODUCT OR NEW MARKET

When a new product is manufactured or when an existing product is revised, new equipment is often required.

capital spending results


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intangible assets used by companiestrademarksbrand namescopyrightspatentssoftware licensing agreements

intellectual property


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GOVERNMENT-REQUIRED PROJECT

Government regulations require compliance from every organization.


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SOCIAL BENEFIT PROJECT

Sometimes a company will undertake a project not directly related to its business.


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Describe the five main types of capital projects.


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Project Selection Factors

INDEPENDENT PROJECTSindependent projects

projects are not affected by each other


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MUTUALLY EXLUSIVE PROJECTS

mutually exclusive projectssituations in which the acceptance of one project does not allow acceptance of others


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COMPLEMENTARY PROJECTS

complementary projectswhen two or more projects are dependent on each other


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How do mutually exclusive projects differ from complementary projects?


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Lesson 6.2

Capital Budgeting Process

GoalsDiscuss the steps in the capital budgeting process.Explain factors that affect the cost of capital.


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Terms

cost of capitalcost of debtcost of equityoptimal capital structureweighted average cost of capital (WACC)


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Making Capital Decisions

The purchase of long-term assets is vital for the current and future success of every organization.capital budgeting

the process of selecting long-term assets


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1. SET CAPITAL SPENDING GOALS

Organizational goals should influence the selection of capital projects.maximize the value of the firm

the goal of a business


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improved community servicereduced operating costsexpanded visibility to attract additional donations

Non-profits have different capital spending goals.


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2. DETERMINE POTENTIAL PROJECTS

The clear identification of capital spending goals helps determine appropriate projects to work on in support of those goals.


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3. FORECAST CASH FLOWS

A quantitative project analysis needs to be prepared.

reflecting the cash inflows and outflows that are a direct result of the project

cash inflowsadditional net sales and revenuesreduced operating expenses


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inflationdepreciation

the decrease in the value of an item as a result of time and usenot part of cash flow calculations

non-cash itemmoney is not paid out when depreciation is recorded

Other factors to consider include:


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4. IDENTIFY COST OF CAPITAL AND RISK

cost of capital (discount rate)the interest rate used to evaluate a capital project a percentage

potential risks are identified and assessedhigh risk can increase the cost of capital


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5. SELECT AND IMPLEMENT PROJECT

Managers decide which capital projects will be selected.

quantitative and qualitative factors will be considered

The management team puts the selected projects into operation.


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What are the steps of the capital budgeting process?


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Cost of Capital

cost of capital (required rate of return)the rate required by lenders and investors who are letting the company use their money


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COST OF DEBT

cost of debtthe rate of return required by creditors

Benefits associated with using debt include:

The company is using the money of others, allowing the business to keep its funds available for other uses.


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The cost of capital is lower than other funding sources as a result of the lower risk for lenders.Interest payments on debt are tax deductible as a business expense.

Creditor risk is lower since debts are legal obligations.


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COST OF EQUITY

cost of equitythe required return of the owners of a companythe percent the company owners expect to earn based on the money they have invested in the companyreturn might be in

dividendsincreased market value of company


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OPTIMAL CAPITAL STRUCTURE

optimal capital structurean appropriate balance between the amount of debt and the amount of equitythe financing combination of a low cost of capital and maximum market value


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The company’s current debt obligationsThe company’s ability to borrow additional funds or issue additional bondsStockholders’ sensitivity to current risk because of existing debtHistorical and projected profitability of the company

Factors to consider when seeking optimal cash structure include


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WEIGHTED AVERAGE COST OF CAPITAL (WACC)

weighted average cost of capital(WACC)

calculated by multiplying the proportions of debt and equity times the capital cost for each


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Every organization attempts to minimize its WACC.

occurs when a certain combination of debt and equity are usedthe exact combination varies across companies and changes as risk and interest rates change


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Why is the cost of debt lower than the cost of equity?


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Lesson 6.3

Capital Project Analysis

GoalsDescribe tools used to analyze capital projects.Explain factors that influence capital project decisions.


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Termspayback methodnet present value (NPV)internal rate of return (IRR)sunk cost


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Capital Decision Tools

PAYBACK METHODpayback method

determines how long it will take for the cash flows of a capital project to equal the original cost

drawbacks to the payback methodfavors short-term projects which may not be in the best interest of the companyneglects the time value of money


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NET PRESENT VALUE

net present value (NPV)calculates the present value of cash flows for a project minus the initial investment


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initial investment (start-up cost)cost of the project

cash flowsannual amounts of increased sales or decreased coststhe financial benefits of the project

cost of capital (discount rate)the interest rate the company will use to calculate the present value of the cash flows

Components of NPV include:


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CALCULATE NET PRESENT VALUE

Step 1Calculate the present value of cash flows.

Step 2Subtract the initial cost from the total in Step 1.

Step 3Evaluate the result.


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If the NPV is negative, reject the project.When considering several projects, accept the one with the highest NPV.

If the NPV is positive, accept the project.


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INTERNAL RATE OF RETURN

internal rate of return (IRR)the discount rate at which the net present value is zeroprovides a rate of return for a capital projectreports a percentage rather than a dollar amount


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What three decision-making tools are commonly used to evaluate capital projects?


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Additional Analysis Factors

OPPORTUNITY COSTthe value of the alternative that is given up when a decision is madecannot always be measured in monetary value


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SUNK COST

sunk costan expense that has been paid that will not affect capital decisions


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RISK ANALYSIS

Risk can be viewed from a variety of perspectives.

GeographyEconomic Conditions


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informal trade barrierscultural differences that lead to uncertainties when doing business in different regions

Political and Legal Restrictionsformal trade barriers

specific government regulations restricting certain business activities

Social and Cultural Factors


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How do opportunity costs and sunk costs differ?


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Lesson 6.4

Business Expansion Strategies

GoalsExplain business growth and expansion actions.Identify actions for reducing global business risks.


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Termscentralized organizationdecentralized organizationhorizontal integrationvertical integrationdiversificationjoint venture


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Business Growth Actions

ORGANIZATIONAL STRATEGIEScentralized organization

decisions are made at company headquarters

decentralized organizationallows company decisions to be made at lower levels of the organization


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EXPANSION METHODS

horizontal integrationa merger between two or more companies in the same type of business

vertical integrationa company expands through increased involvement in different stages of production and distribution


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PRODUCT VARIATIONS

Growth often occurs by offering more and different products.

new flavorsdifferent package sizesvaried brands


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DIVERSITY OF MARKETS

marketwhere and to whom a business sells

B2C (business to consumer)B2B (business to business)


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How does a centralized organization differ from a decentralized one?


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Reducing Global Risks

There are four suggested methods for reducing international business risk.


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CONDUCT BUSINESS IN SEVERAL REGIONS

Political unrest or poor economic conditions can lead to lower profits.

Conducting business in multiple regions of the world reduces risk.


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DIVERSIFY PRODUCT LINES

diversificationoffering a variety of products or servicesallows a company to balance lower sales in one division with higher sales in its other product lines


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INVOLVE LOCAL OWNERSHIP

joint venturean agreement between two or more companies to share a business project


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EMPLOY LOCAL MANAGEMENT

local managerscan create favorable business relationships in a foreign business environmenthave knowledge of local customs and cultural business practices


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What actions can be taken to reduce global business risk?


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Performance Indicators Evaluated

Identify the business’s customer service offerings.Design a marketing research study to determine the clientele’s customer service preferences.Conduct the market research.Compare customer service offerings.


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Prepare a promotional campaign to promote the business’s proposed customer service offerings based on the market research.Present the research findings and proposed promotional campaign to the business’s manager in a role-play situation.

Recommend improvements for customer service offerings.


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Think Critically1. Why is it important for a company to know

what the competition offers for customer service?

2. Why is accurate marketing research so important?


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4. What incentives can be used to encourage customers to participate in a marketing research survey?

3. What is the advantage of a company using a third party to conduct research and make recommendations?

6.1 capital projects 6.2 capital budgeting process …myfinanceclass.com/files/101669450.pdf ·...

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