How Fundamental of Corporate Finance 3rd Edition Can help you Evaluate Capital Budgeting Decisions
Capital budgeting is the practice of investigating projects and at the same time making the assessments of whether they should be incorporated into the capital budget or not. Capital budgeting is of great importance. It majorly determines the success or failure of the firm or organization. This happens because the choices related to the fixed asset investment outlines the progression of a company in the upcoming years.
The Payback Period is one of the best capital budgeting method. It allow companies to calculate how long it will take to recoup the outlay for an investment, the Net present value (NPV), Internal rate of return and Profitability index. For a more detailed understanding of the evaluation of capital budgeting decisions go through the Fundamentals of Corporate Finance 3rd Edition
What is the Cost of Capital?
If we talk about the Cost of capital, it is one of the monument parts of corporate finance. The determination of the cost of capital is precisely the required return necessary to make a capital budgeting project. For example: if constructing a new factory, worthy. The Cost of capital takes in to account the cost of debt as well as the cost of equity. It is employed by different companies internally so as to evaluate if a capital project is worth the disbursement of the resources, moreover in case of the investors, they will use it to decide whether or not the investment is worth taking the risk in comparison to the return.
The overall cost of capital is derived from a weighted average of all capital sources, it is generally known as the weighted average cost of capital (WACC). As the cost of capital epitomizes a hurdle rate that a company must overcome before it can start generating value. It is comprehensively employed in the capital budgeting procedure to make the final decision about proceeding with a project.
Why is it imperative for the financial analyst to focus on incremental cash flows; overlook financing costs, consider taxes, and the adjustment for non-cash expenses when assessing a project’s relevant cash flows?
- To accurately gauge the costs and profits of a capital investment project, a manager shall be able to categorize the additional cash inflows as well as the outflows that will eventually result from the approval of the project, so only these incremental CFs are significant.
- An analyst should disregard the financing costs for the individual projects and instead should use a single weighted average cost of capital for evaluating overall capital investment projects that have the same risk as the firm’s other assets.
- Taxes impact the capital budgeting decision since they can modify the net value of cash flows received or paid out resulting due to the successful projects.
- Non-cash expenses are imperative if these reduce the taxes that must be paid on incremental cash inflows. The most chief non-cash expense for most firms is depreciation, and this deduction works to reduce the tax liabilities of cost-effective firms.
Cost of Capital and Funding Sources
The decisions to choose the sources to fund for any capital budgeting vary from one company another. It primarily depends on the factors such as the company’s operating history, its overall profitability, the creditworthiness, etc. As a matter of fact, the newly established companies that have a limited operating history. Such new setups usually have comparatively higher costs of capital than the established setups that have a solid track record. For a detailed study about the cost of capital, strategies, evaluations of the project economics and the cash flows, counting on the famous book Fundamentals of Corporate Finance 3rd Edition is certainly the best option.