CAPITAL BUDGETING

FOCUS

Our focus in this first capital budgeting chapter begins with the time value concepts behind methods and then moves on to computational and decision making techniques. The problems of cash flow estimation and risk encountered in practice are touched upon here in anticipation of a detailed treatment in a later chapter.

PEDAGOGY

A brief overview of the cost of capital concept is presented early in the chapter even though it is the subject of Chapter 13. The knowledge is necessary to understand and motivate the capital budgeting models. It relates NPV - IRR procedures to the required rate of return idea, something with which students are already familiar. We explicitly tie NPV and IRR together by emphasizing that the IRR comes from the NPV equation as the interest rate that sets NPV=0. This helps to develop an overall understanding of both procedures.

TEACHING OBJECTIVES

After this chapter students should:

1. appreciate the discounted cash flow basis of capital budgeting theory, and 2. be able to make the computations associated with the major capital budgeting techniques. They should also be marginally aware of the difficulties associated with estimating cash flows and differences in project risk. Along these lines, care should be taken not to form the impression that capital budgeting is an engineering-like process that always gives exactly the right answer.

OUTLINE

I. CHARACTERISTICS OF BUSINESS PROJECTS

The nature of projects requiring capital budgeting decisions. A. Project Types and Risk

Replacement, expansion, and new venture projects and their order of risk. B. Stand-alone and Mutually Exclusive Projects

Projects considered by themselves and in competition with one another. C. Project Cash Flows

Representing projects as streams of cash for analysis.

D. The Cost of Capital

A brief introduction to the concept of cost of capital at this point makes the NPV and IRR techniques easier to understand.

II.CAPITAL BUDGETING TECHNIQUES

A general statement defining the techniques as methods of analysis and decision making. A.Payback Period

The payback method explained and illustrated. Its uses and drawbacks discussed. B.Net Present Value (NPV)

The NPV concept and the defining equation. The relationship to shareholder wealth. Calculations, decision rules, and applications. C.Internal Rate of Return (IRR)

The IRR concept and the relation to a required rate of return. The defining equation and its relationship to NPV. Decision rules, calculations, and examples. D.Comparing IRR and NPV

Which is better and why. Possible conflicts

E.NPV and IRR Solutions Using Financial Calculators and Spreadsheets

Instruction on using calculators and spreadsheets in capital budgeting.

F.Projects With A Single Outflow and Regular Inflows

Solution techniques when annuity methods are possible.

G.Profitability Index (PI)

PI as a variation on the NPV concept. Decision rules, calculations, and examples.

H.Comparing Projects with Unequal Lives

Chaining and Equivalent Annual Annuity methods.

I.Capital Rationing

Allocating a limited Capital Budget among available projects.

QUESTIONS

1. Define mutual exclusivity and describe ways in which projects can be mutually exclusive.

ANSWER: A mutually exclusive decision is one in which the selection of any option precludes the selection of all others. In other words, you can't "do both." Mutual exclusivity can be rooted in either the nature of the project or in the availability of resources. Replacements and many expansion projects tend to be mutually exclusive, because there's just one job to be done. Once the method of getting it accomplished is selected, there are simply no other opportunities. Other expansion projects and most new ventures tend to be mutually exclusive because of...