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