Chapter 11

Capital budgeting

the process of measuring the attractiveness of a project

Capital budgeting elements

analysis of potential additions to fixed assets, long-term decisions that involve large expenditures, & very important to firm’s future

How projects are classified

independent, mutually exclusive, and contingent

Independent

acceptance or rejection of a project has no effect on acceptance of other projects

Mutually exclusive

acceptance of one automatically rejects the others

Contingent

acceptance is dependent upon the selection of another

Steps to capital budgeting

estimate cash flows, assess riskiness of cash flows, determine the appropriate cost of capital, and apply capital budgeting techniques

Payback period

length of time required for an investment’s cash flows to cover its cost

Payback period formula

years before the year of recovery plus amount left to be recovered divided by cashflow during the year of final recovery

Advantage of payback method

easy to calculate & understand

Disadvantage of payback method

ignores the time value of money & cash flows occurring after the payback period

Discounted payback period

length of time required for an investment’s cash flows, discounted at the investment’s cost of capital, to cover its cost

Net present value

difference between the present value of its benefits and the present value of its costs; if it is greater than zero, accept

Internal Rate of Return

required return that makes the npv=0 when it is used as the discount rate; if the IRR > the required return, accept

Where do NPV and IRR disagree?

non-conventional cash flows & mutually exclusive projects

Non-conventional cash flows

cash flow signs change more than once

Whenever there is a conflict between NPV and another, always

use NPV

NPV profile

graph showing the relationship between a project’s NPV and the firm’s cost of capital

Crossover rate

cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects’ NPVs are equal