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CB process, measurements
Leels of CB Decision
Paybac3
Profitability inde#
!inancing
7nest in projects that yield a return greater than the minimum
acceptable hurdle rate*
A The hurdle rate should be higher for ris3ier projects and reflect
the financing mi# used + o1ners. funds Be2uityC or borro1ed money
BdebtC
A 9eturns on projects should be measured based on cash flo1s
generated and the timing of these cash flo1s, they should also
consider both positie and negatie side effects of these projects*
Choose a financing mi# that minimi/es the hurdle rate and
matches the assets being financed*
Cost o" Capital
The opportunity cost of an inestment, that is, the rate of return that
a company 1ould other1ise be able to earn at the same ris3 leel as
the inestment that has been selected* !or e#ample, 1hen an
inestor purchases stoc3 in a company, he?she e#pects to see a
return on that inestment* Since the indiidual e#pects to get bac3
more than his?her initial inestment, the cost of capital is e2ual to
this return that the inestor receies, or the money that the company
misses out on by selling its stoc3*
<urdle 9ate
The re2uired rate of return in a discounted cash flo1 analysis, aboe
1hich an inestment ma3es sense and belo1 1hich it does not*
>ften, this is based on the firmDs cost of capital or 1eighted aerage
cost of capital, plus or minus a ris3 premium to reflect the projectDs
specific ris3 characteristics* also called re2uired rate of return*
'(eig)ted aerage #ost o" #apital
"#pected return on a portfolio of all the firmDs securities*
=sed as a hurdle rate for capital inestment*
'Cost o" #apital
The re2uired return for a capital budgeting project*
'*urdle rate
The re2uired return in capital budgeting*
Deriation o" t)e *urdle %ate
The hurdle rate is deried from the cost of capital* This is
the aerage cost of funds that a company uses, and is
based on the aerage cost of its debt, e2uity, and arious
other funding sources that are combinations of these t1o
basic forms of funds*
!or e#ample, if a company has determined its cost of capital
to be %EF, then the discounted cash flo1s from all of its
ne1 capital inestments, using that discount rate, must yield
a positie return* 7f they do not, then the funds flo1
resulting from its capital inestments 1ill not be sufficient for
the company to pay for the funds it inested*
Thus, the primary basis upon 1hich to reie1 potential
capital inestments is the hurdle rate*
Example:
) company may choose to use seeral hurdle rates, depending on the
nature of the inestment* !or e#ample, if the company must install
e2uipment to ma3e its production emissions compliant 1ith PCB 2uality
standards, then there is no hurdle rate at all A the company must complete
the 1or3, or be fined by the goernment*
)t the opposite e#treme, a company may assign a high hurdle rate to all
projects that are considered unusually ris3y* !or e#ample, if capital
projects are for the e#tension of a current production line, there is ery little
perceied ris3, and a hurdle rate that matches the cost of capital is
deemed sufficient*
<o1eer, if the capital e#penditure is for a production line that creates
e2uipment in a ne1 mar3et, 1here the company is the first entrant, and no
one 3no1s 1hat 3ind of sales 1ill result, the hurdle rate may be set a
number of percentage points higher than the cost of capital* Thus,
different hurdle rates can apply to different situations*
Leels o" de#ision ma+ing
De#ision Appli#ations ,"or example- De#ided b!
>perating
decisions
9outine maintenance and
minor office e2uipment
Lo1er+leel mgmt*
)dministratie
decisions
Gearly maintenance and
Balancing e2uipment
8iddle+leel mgmt
Strategic
decisions
"#pansions, diersifications Top+leel mgmt?Board
7n addition to arious phases of capital budgeting, it is
important to loo3 at different leels of decision+ma3ing*
These are operating, administratie and strategic
decision ma3ing leels*
.ACETS &. P%&/ECT ANAL0SIS
8ar3et analysis
Technical analysis
!inancial analysis
"conomic analysis
"cological analysis
8)9H"T ):)LGS7S
%
st
step in project analysis
Purpose:
Location
Si/e
Process*******
!7:):C7)L ):)LGS7S
Purpose:
Financial viability of the project.