capital budgeting

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Notes: FIN 303 Spring 09, Part 7 – Capital Budgeting

Professor James P. Dow, Jr.

Part 7. Capital Budgeting
What is Capital Budgeting?
Nancy Garcia and Digital Solutions

Digital Solutions, a software development house, is considering a number of new projects, including a joint venture with another company. Digital Solutions would provide the software expertise to do the development, while the other company, American Financial Consultants
(AFC) would be responsible for the marketing. Nancy Garcia of Digital Solutions would be responsible for assessing the financial viability of the plan. Information about the costs and revenues of the project would come from the accounting, production and marketing groups of the two companies; however, Ms. Garcia would have to put the information together, and provide a preliminary analysis that she would present to the company’s managers.
Capital budgeting is the process of making a decision about the financial desirability of a project. The proposed software development project at Digital Solutions is an example of this kind of problem. We will see how Nancy Garcia approaches this problem as a way to learn the techniques of capital budgeting.
The Big Picture

Businesses are about increasing the wealth of their owners, which means that they should pursue all the profitable projects that they can. Capital budgeting is about deciding which projects are profitable and add to the value of the firm.
Sometimes the firm has to choose between two or more projects and can only pick one. For example, you may have a choice between two air-conditioning systems with different installation costs and energy costs. Your decision to install one rules out the installation of the other. Both systems may be wealth improving but you can’t accept both. You want to pick the one that increases wealth by the most. When you have mutually exclusive projects, such as in this situation, you take a ranking approach to decision

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