UNIT VII STUDY GUIDE Capital Budgeting

UNIT VII STUDY GUIDE Capital Budgeting

Author: Emma Drink


UNIT VII STUDY GUIDECapital BudgetingLearning ObjectivesReadingAssignmentChapter 10:Capital BudgetingKey Terms1. Cost of capital2. Internal rate of return(IRR)3. Mutually exclusive4. Net present value(NPV)5. Payback period6. Profitability index (PI)7. Stand aloneUpon completion of this unit, students should be able to:1. Contrast mutually exclusive project decisions and stand-alone projectdecisions.2. Calculate payback periods.3. Calculate net present value (NPV) for various investment projects.4. Calculate internal rate of return (IRR) using Excel.5. Calculate the profitability index (PI) to compare capital projects.6. Contrast results from various capital budgeting techniques by assessingthe strengths and weaknesses.Written LectureThis unit combines tools from time value of money and applies them to the mostimportant element of management, long-term planning. The managerial functionis concerned with the allocation of resources and the deployment of capital(money) to long-term projects and is pivotal to the life of a business.Capital budgeting involves the planning of large expenditures on long-term(capital) projects. Ranked in order of increasing risk, common categories ofcapital budgeting include replacement, expansion, or new products/ventures.Capital budgeting projects can be further classified as either stand-alone ormutually exclusive. A stand-alone project has no competing alternatives.Mutually exclusive projects involve selecting one project from among two ormore alternatives. Mutual exclusivity may be due to constraints in budget(amount), or limited resources (available land, human resources, machinery,etc.).The typical structure of a capital budgeting analysis involves a negative initialoutlay, then a series of positive cash flows such as those provided below:ExampleC0C1C2C3C4C5$(50,000)15,00015,00015,00015,00015,000The above example will be used to illustrate the commonly used capitalbudgeting techniques. The following techniques are stressed in this unit:Payback Period: determines how many years it takes to recover initial cost.Using this method, shorter paybacks are better (when comparing mutuallyexclusive projects). Payback is often considered the “weakest” capitalbudgeting tool as it does not consider time value of money or the cash flowsafter the payback period.BBA 3301, Financial Management1Using the above example the payback is: 3.33 years. After three years, it hasthrecovered $45,000, thus only $5,000 is needed from the 4 year.$5,000/$15,000 results in .33 year.Net Present Value (NPV): determines present value of inflows less outflows.Specifically, NPV is the sum of the present values of a project’s cash flows atthe cost of capital. The cost of capital is the average rate a firm pays investorsfor use of its long term money which comes from two sources, debt and equity.To maximize shareholder wealth, select the capital spending program with thehighest NPV.

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