Reading 35: Capital Budgeting (Mutually exclusive projects, project…
Reading 35: Capital Budgeting
Process and categories
Capital budgeting process
Step 1: Generate investment ideas
Step 2: Analyze project ideas
Step 3: Create firm-wide capital budget
Step 4: Monitor decisions and conduct a post-audit
Capital project categories
(for maintaining business, or cost reduction)
New products or market development project
(to meet environmental or regulatory requirements)
(R&D, senior management projects)
based on incremental after-tax cash flows
Sunk costs (already incurred) are not considered
Externalities and cash opportunity cost must be included.
Mutually exclusive projects, project sequencing & capital rationing
Acceptable independent projects can all be taken
For mutually exclusive project, firm can only choose 1
: concerns the opportunities for future capital project that may be created by taking a current project.
firm shpuld prefer the group of fundable positive NPV projects with the highest NPV
NPV, IRR, Payback period, Discounted payback period, profitability index (PI)
NPV: Net Present Value
Positive NPV projects should be taken. Negative NPV would reduce the value of the firm.
IRR: the discount rate that equates the present values of the project's expected cash inflow and outflow (NPV = 0)
Projects with unconventional cash flow pattern cane produce multiple IRRs or no IRR.
Payback period & Discounted payback period
The time taken to recover the project original cost (with or without considering time value of money)
Profitability Index (PI)
ratio of PV(project's future cash flow) and its initial outlay
PI > 1 for positive-NPV project, < 1 for negative-NPV Project
plots a project's NPV as a function of the discount rate (Vertical axis is NPV, horizontal is discount rate).
If 2 NPV profiles intersect at some discount rate, that is the
, and the different project are preferred at discount rate higher or lower than the crossover rate.