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Capital budgeting
Tools used to evaluate investments in long lived capacity resources.

Time value of money
$1 today is worth more than $1 a year from now.

4 elements of project cash flows
 1. initial outlay
 2.Estimated life and salvage value of asset
 3. Operating cash flows for each year of asset life
 4.Cost of capital

Initial outlay
All upfront costs incurred to ready the asset for its intended use.(Purchase price+costs of delivery,installation etc)

Asset life
How long we're going to use an asset

salvage value
residual value from disposing of the asset at the end of its useful life.

cost of capital
rate of return that providers of capital expect from their investment.

NPV(definition)
total present value of all cash flows from a project

NPV formula
 Net cash flows in whichever period it is
 1
 (1+r)^(whichever period is)
 do this for each period and add them all up

IRR (definition)
Discount rate in which NPV is zero

in IRR the project is profitable if_______
IRR>cost of capital

Payback period(definition)
how long it takes to recoup the initial investment

payback period(formula)
 initial outlay/annual cash flow
 (only used if cash flows are the same in all years)

modified payback(formula)
 net cash flow*present value factor.
 (add these up until initial outlay is paid back)

accounting rate of return(formula)
 average annual income from project
 average investment

annual income(formula)
annual cash flowdepreciation

average investment(aka average book value of asset)(formula)
(beginning book value=ending book value)/2

decentralization
need to measure and evaluate performance of managers of individual divisions or business units within the firm.

3 types of responsibility centers
 1. cost center
 2. profit center
 3. investment center

cost center
controls costs, but not revenues or investments

profit center
controls costs and revenues, but not investments.

investment center
controls costs, revenues and investments

Two main goals for cost center managers(short and long term)
 short term: achieving cost targets for a given level of output.
 longterm: continuous efficiency improvements to reduce costs.

Short term performance measures for cost center managers
Usually, focus on flexible budget variances.

long term performance measures for cost center managers
benchmarking and Kaizen

benchmarking
compare efficiency of various activities and business processes in the firm against best practices in the industry.

kaizen
(continuous improvement): hold managers accountable for achieving sustained cost reduction.

3 main measures to evaluate performance of investment centers.
 return on investment
 residual income
 Economic value added

ROI(formula)
 Profit/investment
 OR
 Profit margin*asset turnover

profit margin(formula)
profit/sales

Asset turnover(formula)
sales/investment

Residual income(aka RI) (formula)
Profit(required rate of return*investment)

economic value added(formula)
NOPAT{WACC*(invested capitalcurrent liabilities)

Net operating profit after taxes(aka NOPAT) (formula)
(1taxrate)*net operating profit before taxes

WACC(definition)
weighted average cost of capital

