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