Chapter 8: Capital Budgeting Decision Rules

Capital budgeting

The processs where a firm uses investor capital to expand the shareholder wealth.

Net present value rule

Measures the value of an opportunity in today’s dollars. The result tells you how much value is created for firm owners TODAY if the project is accepted.

Free cash flow

The cash flow that a project has generated prior to paying investors for a particular year or time period.

Cost of capital

The r in the formula and represents the return that our investors (ALL) want on this project. This is the present value of the benefits from the project.

Internal rate of return (IRR)

Represents the rate of return earned on every dollar invested in the project. Is a percentage measure of the project’s success. Also the interest rate that sets the NPV of a project equal to zero.

Independent

Selecting a projecting will not prevent a firm from taking another project.

Mutually exclusive

The firm takes the best project at the expense of the other projects. So, taking one project will prevent the firm from taking another.

Contingent

The firm has to take several projects together or reject all of the projects. The choice is then either accept all projects or none.

Multiple internal rates of return

Occurs when project cash flows switch sign more than once.

Payback rule

Calculates how long it takes to recover the initial investment in the project.

Discounted payback rule

Calculates the amount of time it takes to recover the initial investment in a project.

Profitability index or PI ratio

Allows us to rank projects by efficiency. It is a cost-benefit measure that is useful when a firm is constrained by some resource needed for projects.

Modified internal rate of return (MIRR)

Makes the assumption that the cash flows created by a project can be re-invested at the firm’s cost of capital. So, we take each cash flow paid by the project and find its future value at the end of the project.