CAPITAL BUDGETING

Overview 159

7.1 The NPV Rule for Judging Investments

and Projects 159

7.2 The IRR Rule for Judging Investments 161

7.3 NPV or IRR, Which to Use? 162

7.4 The “Yes–No” Criterion: When Do IRR and NPV Give

the Same Answer? 163

7.5 Do NPV and IRR Produce the Same Project

Rankings? 164

7.6 Capital Budgeting Principle: Ignore Sunk Costs and

Consider Only Marginal Cash Flows 168

7.7 Capital Budgeting Principle: Don’t Forget the Effects

of Taxes—Sally and Dave’s Condo Investment 169

7.8 Capital Budgeting and Salvage Values 176

7.9 Capital Budgeting Principle: Don’t Forget the Cost

of Foregone Opportunities 180

7.10 In-House Copying or Outsourcing? A Mini-case

Illustrating Foregone Opportunity Costs 181

7.11 Accelerated Depreciation 184

Conclusion 185

Exercises 186

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CHAPTER 7 Introduction to Capital Budgeting 159

OVERVIEW

Capital budgeting is finance terminology for the process of deciding whether or not to undertake an investment project. There are two standard concepts used in capital budgeting: net present value (NPV) and internal rate of return (IRR). Both of these concepts were introduced in Chapter 5; in this chapter we discuss their application to capital budgeting. Here are some of the topics covered:

• Should you undertake a specific project? We call this the “yes–no” decision, and we show how both NPV and IRR answer this question.

• Ranking projects: If you have several alternative investments, only one of which you can choose, which should you undertake?

• Should you use IRR or NPV? Sometimes the IRR and NPV decision criteria give different answers to the yes–no and the ranking decisions. We discuss why this happens and which criterion should be used for capital budgeting (if there’s disagreement). • Sunk costs. How should you account for costs incurred in the past? • The cost of foregone opportunities.

• Salvage values and terminal values.

• Incorporating taxes into the valuation decision. This issue is dealt with briefly in Section 7.7. We return to it at greater length in Chapters 8–10.

Finance Concepts Discussed

• IRR

• NPV

• Project ranking using NPV and IRR

• Terminal value

• Taxation and calculation of cash flows

• Cost of foregone opportunities

• Sunk costs

Excel Functions Used

• NPV

• IRR

• Data Tables

7.1 The NPV Rule for Judging Investments and Projects

In preceding chapters we introduced the basic NPV and IRR concepts and their application to capital budgeting. We start off this chapter by summarizing each of these rules—the NPV rule in this section and the IRR rule in the following section.

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Here’s a summary of the decision criteria for investments implied by the net present value: The NPV rule for deciding whether or not a specific project is worthwhile: Suppose you are considering a project that has cash flows CF0, CF1, CF2, . . . , CFN. Suppose that the appropriate discount rate for this project is r. Then the NPV of the project is NPV = CF0 + CF1

(1 + r )

+ CF2

(1 + r )2

+ · · ·+ CFN

(1 + r )N

= CF0 +

N

t=1

CFt

(1 + r )t

Rule: A project is worthwhile by the NPV rule if its NPV 0. The NPV rule for deciding between two mutually exclusive projects: Suppose you are trying to decide between two projects A and B, each of which can achieve the same objective. For example, your company needs a new widget machine, and the choice is between widget machine A and machine B. You will buy either A or B (or perhaps neither machine, but you will certainly not buy both machines). In finance jargon, these projects are “mutually exclusive.”

Suppose project A has cash flows CFA0

, CFA1

, CFA2

, . . . , CFA

N and that project B has

cash flows CFB0

, CFB1

, CFB2

, . . . , CFB

N .

Rule: Project A is preferred to project B if

NPV(A) = CFA0

+

N

t=1

CFAt

(1 + r )t > CFB0

+

N

t=1

CFBt

(1 + r )t

= NPV(B)

The...