Provides in-depth summary of chapter 10. topics include Payback Period, Net Present Value (NPV), Profitability Index (PI), Economic Value Added (EVA), Internal Rate of Return (IRR)
Capital Budgeting Techniques
Chapter Number Chapter 10
Subject COF
📖 Table of Contents
Outline
10.1 Overview of Capital Budgeting
MOTIVES FOR CAPITAL EXPENDITURE
STEPS IN THE PROCESS
BASIC TERMINOLOGY
CAPITAL BUDGETING TECHNIQUES
Example
10.2 Payback Period
Example: Bennett Company
PERSONAL FINANCE EXAMPLE
Example: payback calculations fail to account for the time value of money
Example: Ignoring cash flows that arrive after the payback period
10.3 Net Present Value (NPV)
Example: Bennett Company
NPV AND THE PROFITABILITY INDEX (PI)
NPV AND ECONOMIC VALUE ADDED
Example: NPV and EVA
10.4 Internal Rate of Return (IRR)
10.5 Comparing NPV and IRR Techniques
NET PRESENT VALUE PROFILES
Example: Bennett Company
CONFLICTING RANKINGS
Reinvestment Assumption
Timing of the Cash Flow
Magnitude of the Initial Investment
WHICH APPROACH IS BETTER?
Capital Budgeting Techniques 1
, 🚨 Notes from class; What is important to know:
IRR
How does it relate to NPV
How its been calculated?
Why is it calculated?
What are its assumptions?
IF YOU HAVE A HIGHER IRR IT MAYBE MEANS THAT YOU HAD A HIGHER CASH FLOW RATHER THAN
ANNUITIES
Why do you calculate NPV?
for wealth maximization
modified internal rate of return (MIRR)
The MIRR represents the discount rate that causes the terminal value just to equal the initial investment.
→ Using the cost of capital rate
10.1 Overview of Capital Budgeting
Capital budgeting is the process of evaluating and selecting long-term investments that contribute to the firm’s goal of
maximizing owners’ wealth.
MOTIVES FOR CAPITAL EXPENDITURE
📍 A capital expenditure is an outlay of funds that the firm expects to produce benefits over a period of time greater
than 1 year.
EG. fixed-assets outlays
📍 An operating expenditure is an outlay resulting in benefits received within 1 year.
STEPS IN THE PROCESS
Steps Explanation
proposals for new investment projects → reviewed by finance personnel
STEP 1 Proposal Generation
Proposals that require large outlays receive greater scrutiny
STEP 2 Review and Analysis formal review and analysis to assess the merits
STEP 3 Decision Making delegate capital expenditure decisions on the basis of dollar limits
STEP 4 Implementation firms make expenditures and implement projects
monitor results and compare actual costs and benefits to the projections to
STEP 5 Follow-up
justify investment
BASIC TERMINOLOGY
Independent Projects Mutually Exclusive Projects
those with cash flows unrelated to (or independent Projects that compete with one another so that the
of) one another; accepting or rejecting one project vs acceptance of one eliminates from further
does not change the desirability of other projects. consideration all other projects that serve a similar
〰️〰️〰️〰️〰️〰️〰️〰️〰️〰️〰️〰️ function.
Unlimited Funds 〰️〰️〰️〰️〰️〰️〰️〰️〰️〰️〰️〰️
firm is able to accept all independent projects that Capital Rationing
provide an acceptable return.
Capital Budgeting Techniques 2
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