Capital Budgeting
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Capital Budgeting
What is Capital Budgeting?
Capital Budgeting Process

• Identification of Potential Investment Opportunities
• Assembling of Investment Proposals
• Decision Making
• Preparation of Capital Budget & Appropriations
• Implementation
• Performance Review
Capital Budgeting Process
• Generate investment proposals consistent with the firm’s strategic objectives.
• Evaluate project incremental cash flows.
• Select projects based on a value-maximizing acceptance criterion.
• Reevaluate implemented investment projects continually and perform post-audits for completed projects.
Classification of Investment Project Proposals
• Replacement
• Cost reduction
• Expansion of new products and/or markets
• Research & development
• Exploration
• Government Regulations
Project Evaluation: Alternative Methods
– Payback Period (PBP)
– Internal Rate of Return (IRR)
– Net Present Value (NPV)
– Profitability Index (PI)
Proposed Project Data
Julie is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the cash flows for the project will be 10,000; 12,000; 15,000; 10,000; and 7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be 40,000.
• Payback Period
• Payback Solution
• Net Present Value
• NPV Solution
• NPV Solution
• NPV Acceptance Criterion
Internal Rate of Return (IRR)
• IRR Solution
• IRR Acceptance Criterion
• Profitability Index (PI)
• PI Acceptance Criterion
• Evaluation Summary
Other Project Relationships
Dependent -- A project whose acceptance depends on the acceptance of one or more other projects.
Mutually Exclusive -- A project whose acceptance precludes the acceptance of one or more alternative projects.
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
• A. Scale Differences
• Scale Differences
• B. Cash Flow Pattern
• Cash Flow Pattern
• C. Project Life Differences
• Project Life Differences
• Capital Rationing
Available Projects for BW
Project ICO IRR NPV PI
A 500 18% 50 1.10 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 E 12,500 26 500 1.04 F 15,000 28 21,000 2.40 G 17,500 19 7,500 1.43 H 25,000 15 6,000 1.24
Choosing by IRRs for BW
Project ICO IRR NPV PI
C 5,000 37% 5,500 2.10 F 15,000 28 21,000 2.40 E 12,500 26 500 1.04 B 5,000 25 6,500 2.30
Projects C, F, and E have the three largest IRRs.
The resulting increase in shareholder wealth is 27,000 with a 32,500 outlay.
Choosing by NPVs for BW
Project ICO IRR NPV PI
F 15,000 28% 21,000 2.40 G 17,500 19 7,500 1.43 B 5,000 25 6,500 2.30
Projects F and G have the two largest NPVs.
The resulting increase in shareholder wealth is 28,500 with a 32,500 outlay.
Choosing by PIs for BW
Project ICO IRR NPV PI
F 15,000 28% 21,000 2.40
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is 38,000 with a 32,500 outlay.
Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D 38,000
NPV F and G 28,500
IRR C, F, and E 27,000
PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.
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