Professor James P. Dow, Jr.

Part 8. Topics in Capital Budgeting

In part 7 we learned the basics of capital budgeting. However, we ignored some of the complications that can arise when evaluating projects. In this section we look at a few of those issues. How Uncertainty Affects the Capital Budgeting Decision

Every project has uncertainty and so we need to determine how risk affects how we make decisions. Large corporations often use very sophisticated methods to incorporate risk into capital budgeting, but every businessperson needs to know a few basic techniques for evaluating uncertainty. Break-Even Analysis

It is often useful to know at what point a project neither makes nor loses money – the break-even point. Often managers have a sense of whether the project could at least make that level. For example, imagine a project that has a fixed cost of $100,000 and earns on net $4 per unit sold.

You expect to sell 35,000 units, which generates a profit of $40,000 (35,000*$4 - $100,000 =

$40,000). The break even-point is 25,000 units (25,000*4-$100,000=0). You might be wrong about selling 35,000 units, but if you know that the project will sell at least 25,000 units then you know you won’t lose money, and would feel more confident about going ahead with the project.

Example: The upfront cost of a project is $100,000. Sales are for five years, starting next year. The company earns $0.50 per sale, and expects to sell 60,000 units per year.

If the interest rate is 5%, the NPV is -100,000 +129,884 = 29,884. At what level of sales does the project break even in terms of NPV?

Set PV = -100,000 (so that NPV = 0) and find the amount of sales per year. The answer is sales in dollars = 23,097 so that sales in units = 46,194.

Break-even analysis is a good starting point, but it ignores some important information. It doesn’t tell us the probability of getting a specific result or how good or bad the results could