Capital Budgeting

Topics: Net present value, Costs, Variable cost Pages: 15 (5872 words) Published: October 6, 2014
Capital Budgeting
Read Chaptes 7,8 & 9
Problems from Chapter 7 : 1 to 28
Chapter 8 : 1 to 23
Chapter 9 : 1 to 24

A.The Basic Idea
Net present value—the difference between the market value of an investment and its cost. While estimating cost is usually straightforward, finding the market value of assets can be tricky. The principle is to find the market price of comparables or substitutes.


Using the text example (page 257), the basic idea behind capital budgeting is to ‘add value’. After including all of the costs (cash outflows) and revenues (cash inflows), value is added if the present value of inflows is greater than the present value of outflows.

Although this point may seem rather obvious, it is often helpful to stress the word "Net" in Net Present Value. It is not uncommon for some students to carelessly calculate the PV of a project's inflows and fail to subtract out its cost. The PV of inflows is not NPV; rather NPV is the amount remaining after offsetting the PV of the inflows with the PV of the outflows. Thus, the NPV amount determines the incremental value created by undertaking the investment. B.Estimating Net Present Value

Discounted cash flow (DCF) valuation—finding the market value of assets or their benefits by taking the present value of future cash flows, i.e., by estimating what the future cash flows would trade for in today's dollars.

Net present value rule—an investment should be accepted if the NPV is positive and rejected if it is negative. In other words, if the market value of the benefits is larger than the cost, an investment will increase value.

Here's another perspective on the meaning of NPV. In terms of the present, if we accept a project with a negative NPV of -$2,422, this is financially equivalent to investing $2,422 today and receiving nothing in return. Therefore, the total value of the firm would decrease by $2,422. This, of course, assumes that the various components (cash flow estimates, discount factor, etc.) used in the computation are correct.

First, it should be noted that, in practice, financial managers are rarely presented with zero-NPV projects for at least two reasons. First, in an abstract sense, zero is just another of the infinite number of values the NPV can take; as such, the likelihood of obtaining any particular number is small. Second, (and more pragmatically), in most large firms, capital investment proposals are submitted to the Finance group from other areas (e.g., the industrial engineering group) for analysis. Those submitting proposals recognize the ambivalence associated with zero NPVs and are less likely to send them to the Finance group in the first place.

Conceptually, a zero-NPV project earns exactly its required return. Assuming that risk has been adequately accounted for, investing in a zero-NPV project is equivalent to purchasing a financial asset in an efficient market. (Capital market efficiency is discussed later in the text.) In this sense, one would be indifferent between the capital expenditure project and the financial asset investment. Further, since firm value is completely unaffected by the investment, there is no reason for shareholders to prefer either one.

Before leaving this topic, it should be noted that several real-world considerations make comparisons such as the one above difficult. For example, adjusting for risk in capital budgeting projects can be problematic. And, some investment projects may be associated with benefits that are difficult to quantify, but exist, nonetheless. (Consider, for example, an investment with a low or zero NPV but which enhances a firm's image as a good corporate citizen.) Additionally, the secondary market for most physical assets is substantially less efficient than the secondary market for financial assets. While, in theory, one could adjust for differences in liquidity, the adjustment is, again,...
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