Prepared by: Matt H.

Evans, CPA, CMA, CFM

This course provides a concise overview of capital
budetin analysis. This course is reco!!ended
for " hours of Continuin Professional Education. #n
order to receive credit, you will need to pass a
!ultiple choice e$a! which is ad!inistered over
the internet at www.e$inf!.co!%trainin
A co!panion toll free course can be accessed by
dialin &'())'*(+',-+), option ., #/ )0".

E$cellence in Financial Manae!ent

The Overall Process
Capital Expenditures
1henever we !a2e an e$penditure that enerates a cash flow benefit for
!ore than one year, this is a capital e$penditure. E$a!ples include the
purchase of new e3uip!ent, e$pansion of production facilities, buyin
another co!pany, ac3uirin new technoloies, launchin a research 4
develop!ent prora!, etc., etc., etc. Capital e$penditures often involve lare
cash outlays with !a5or i!plications on the future values of the co!pany.
Additionally, once we co!!it to !a2in a capital e$penditure it is so!eti!es
difficult to bac2'out. Therefore, we need to carefully analy6e and evaluate
proposed capital e$penditures.
The Three Stages of Capital Budgeting Analysis
Capital 7udetin Analysis is a process of evaluatin how we invest in capital
assets8 i.e. assets that provide cash flow benefits for !ore than one year. 1e
are tryin to answer the followin 3uestion:
Will the future benefits of this project be large enough to justify the investment
given the risk involved?
#t has been said that how we spend our !oney today deter!ines what our
value will be to!orrow. Therefore, we will focus !uch of our attention on
present values so that we can understand how e$penditures today influence
values in the future. A very popular approach to loo2in at present values of
pro5ects is discounted cash flows or DCF. However, we will learn that this
approach is too narrow for properly evaluatin a pro5ect. 1e will include three
staes within Capital 7udetin Analysis:
/ecision Analysis for 9nowlede 7uildin
:ption Pricin to Establish Position
/iscounted Cash Flow ;/CF< for !a2in the #nvest!ent /ecision
9E= P:#>T /o not force decisions to fit into /iscounted Cash Flows?
=ou need to o throuh a three'stae process: /ecision Analysis, :ption

Chapter
1
Pricin, and /iscounted Cash Flow. This is one of the biest !ista2es
!ade in financial !anae!ent.
Stage 1: ecision Analysis
/ecision'!a2in is increasinly !ore co!ple$ today because of uncertainty.
Additionally, !ost capital pro5ects will involve nu!erous variables and
possible outco!es. For e$a!ple, esti!atin cash flows associated with a
pro5ect involves wor2in capital re3uire!ents, pro5ect ris2, ta$ considerations,
e$pected rates of inflation, and disposal values. 1e have to understand
e$istin !ar2ets to forecast pro5ect revenues, assess co!petitive i!pacts of
the pro5ect, and deter!ine the life cycle of the pro5ect. #f our capital pro5ect
involves production, we have to understand operatin costs, additional
overheads, capacity utili6ation, and start'up costs. Conse3uently, we can not
!anae capital pro5ects by si!ply loo2in at the nu!bers8 i.e. discounted
cash flows. 1e !ust loo2 at the entire decision and assess all relevant
variables and outco!es within an analytical hierarchy.
#n financial !anae!ent, we refer to this analytical hierarchy as the Multiple
Attribute /ecision Model ;MA/M<. Multiple attributes are involved in capital
pro5ects and each attribute in the decision needs to be weihed differently.
1e will use an analytical hierarchy to structure the decision and derive the
i!portance of attributes in relation to one another. 1e can thin2 of MA/M as
a decision tree which brea2s down a co!ple$ decision into co!ponent parts.
This decision tree approach offers several advantaes:
1e syste!atically consider both financial and non'financial criteria.
@ude!ents and assu!ptions are included within the decision based on e$pected
values.
1e focus !ore of our attention on those parts of the decision that are i!portant.
!
Three Stages of Capital Budgeting
/ecision
Analysis
:ption
Pricin
/CF -A
"-A
,-A
*-A
(-A
&--A
B&.-- B".-- B..--
Investment Amount
L
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e
l

o
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a
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1e include the opinions and ideas of others into the decision. Croup or tea! decision
!a2in is usually !uch better than one person analy6in the decision.
Therefore, our first real step in capital budetin is to obtain 2nowlede about
the pro5ect and orani6e this 2nowlede into a decision tree. 1e can use
software prora!s such as E$pert Choice or /ecision Pro to help us build a
decision tree.
Di!ple E$a!ple of a /ecision Tree:
Stage !: Option Pricing
The uncertainty about our pro5ect is first reduced by obtainin 2nowlede and
wor2in the decision throuh a decision tree. The second stae in this
process is to consider all options or choices we have or should have for the
pro5ect. Therefore, before we proceed to discounted cash flows we need to
build a set of options into our pro5ect for !anain une$pected chanes.
#n financial !anae!ent, consideration of options within capital budetin is
called continent clai!s analysis or option pricin. For e$a!ple, suppose you
have a choice between two boiler units for your factory. 7oiler A uses oil and
7oiler 7 can use either oil or natural as. 7ased on traditional approaches to
capital budetin, the least costs boiler was selected for purchase, na!ely
7oiler A. However, if we consider option pricin 7oiler 7 !ay be the best
choice because we have a choice or option on what fuel we can use.
Duppose we e$pect risin oil prices in the ne$t five years. This will result in
hiher operatin costs for 7oiler A, but 7oiler 7 can switch to a second fuel to
better control operatin costs. Conse3uently, we want to assess the options
of capital pro5ects.
:ptions can ta2e !any for!s8 ability to delay, defer, postpone, alter, chane,
etc. These options ive us !ore opportunities for creatin value within capital
pro5ects. 1e need to thin2 of capital pro5ects as a bundle of options. Three
co!!on sources of options are:
&. Ti!in :ptions : The ability to delay our invest!ent in the pro5ect.
". Abandon!ent :ptions : The ability to abandon or et out of a pro5ect that has one bad.
3
.. Crowth :ptions : The ability of a pro5ect to provide lon'ter! rowth despite neative
values. For e$a!ple, a new research prora! !ay appear neative, but it !iht lead to
new product innovations and !ar2et rowth. 1e need to consider the rowth options of
pro5ects.
:ption pricin is the additional value that we reconi6e within a pro5ect
because it has fle$ibilities over si!ilar pro5ects. These fle$ibilities help us
!anae capital pro5ects and therefore, failure to reconi6e option values can
result in an under'valuation of a pro5ect.
Stage 3: iscounted Cash "lo#s
Do we have co!pleted the first two staes of capital budetin analysis: ;&<
7uild and orani6e 2nowlede within a decision tree and ;"< Eeconi6e and
build options within our capital pro5ects. 1e can now !a2e an invest!ent
decision based on /iscounted Cash Flows or /CF.
Fnli2e accountin, financial !anae!ent is concerned with the values of
assets today8 i.e. present values. Dince capital pro5ects provide benefits into
the future and since we want to deter!ine the present value of the pro5ect, we
will discount the future cash flows of a pro5ect to the present.
/iscountin refers to ta2in a future a!ount and findin its value today.
Future values differ fro! present values because of the ti!e value of !oney.
Financial !anae!ent reconi6es the ti!e value of !oney because:
&. Inflation reduces values over ti!e8 i.e. B &,--- today will have less value five years fro!
now due to risin prices ;inflation<.
". Uncertainty in the future8 i.e. we thin2 we will receive B &,--- five years fro! now, but a
lot can happen over the ne$t five years.
.. Opportunity Costs of !oney8 B &,--- today is worth !ore to us than B &,--- five years
fro! now because we can invest B &,--- today and earn a return.
Present values are calculated by referrin to tables or we can use calculators
and spreadsheets for discountin. The discount rate we will use is the
opportunity costs of the invest!ent8 i.e. the rate of return we re3uire on any
other pro5ect with si!ilar ris2s.
E$hibit & G Present Halue of B &.--, year I n, rate I 2
=ear ;n< 2 I &-A 2 I &&A 2 I &"A
& .+-+ .+-& .(+.
" .("* .(&" .)+)
. .)0& .).& .)&"
$
, .*(. .*0+ .*.*
0 .*"& .0+. .0*)
E$a!ple & G Calculate the Present Halue of Cash Flows
=ou will receive B 0-- at the end of ne$t year. #f you could invest the B 0--
today, you esti!ate that you could earn &"A. 1hat is the Present Halue of
this future cash inflowJ
B 0-- $ .(+. ;E$hibit &< I B ,,*.0-
#f we were to receive the sa!e cash flows year after year into the future, then
we could use the present value tables for an annuity.
E$hibit " G Present Halue of Annuity for B &.--, year I n, rate I 2
=ear ;n< 2 I &-A 2 I &&A 2 I &"A
& .+-+ .+-& .(+.
" &.).* &.)&. &.*+-
. ".,() ".,,, ".,-"
, ..&)- ..&-" ..-.)
0 ..)+& ..*+* ..*-0
E$a!ple " G Calculate the Present Halue of Annuity Type Cash Flows
=ou will receive B 0-- each year for the ne$t five years. =our opportunity
costs for this invest!ent is &-A. 1hat is the present value of this
invest!entJ
B 0-- $ ..)+& ;E$hibit "< I B &,(+0.0-
1e now understand discountin of cash flows ;/CF< and the three reasons
why we discount future cash flows: #nflation, Fncertainty, and :pportunity
Costs.
%
Calculating the iscounted Cash "lo#s of
Pro&ects
#n capital budetin analysis we want to deter!ine the after ta$ cash flows
associated with capital pro5ects. 1e are concerned with all relevant chanes
or differences to cash flows once we invest in the pro5ect.
'nderstanding ()elevancy(
:ne 3uestion that we !ust as2 in capital budetin is what is relevant. Here
are so!e e$a!ples of what is relevant to pro5ect cash flows:
&. /epreciation : Capital assets are sub5ect to depreciation and we need to account for
depreciation twice in our calculations of cash flows. 1e deduct depreciation once to
calculate the ta$es we pay on pro5ect revenues and we add bac2 depreciation to arrive at
cash flows because depreciation is a non'cash ite!.
". 1or2in Capital : Ma5or invest!ents !ay re3uire increases to wor2in capital. For
e$a!ple, new production facilities often re3uire !ore inventories and hiher salaries
payable. Therefore, we need to consider the net chane in wor2in capital associated
with our pro5ect. Chanes in net wor2in capital will so!eti!es reverse the!selves at the
end of the pro5ect.
.. :verhead : Many capital pro5ects can result in increases to allocated overheads, such as
co!puter support services. However, the sub5ective nature of overhead allocations !ay
not !a2e any difference at all. Therefore, you need to assess the i!pact of your capital
pro5ect on overhead and deter!ine if these costs are relevant.
,. Financin Costs : #f we plan on financin a capital pro5ect, this will involve additional cash
flows to investors. The best way to account for financin costs is to include the! within
our discount rate. This eli!inates the possibility of double'countin the financin costs by
deductin the! in our cash flows and discountin at our cost of capital which also
includes our financin costs.
1e also need to inore costs that are sun28 i.e. costs that will not chane if
we invest in the pro5ect. For e$a!ple, a new product line !ay re3uire so!e
preli!inary !ar2etin research. This research is done reardless of the
pro5ect and thus, it is sun2. The concept of sun2 costs and relevant costs
applies to all types of financin decisions.
Chapter
!
*
E$a!ple . G Ma2e or 7uy /ecision
=ou have the option to !anufacture your own parts or purchase the! fro!
outside suppliers. #f we purchase the parts, it will cost B 0-.-- per part. :ur
factory is operatin at )-A of capacity and our total costs to !anufacture
parts is:
/irect Materials B &0.-- % part
/irect Kabor B &+.-- % part
:verhead ' Hariable B &,.-- % part
:verhead ' Fi$ed B &".-- % part
Total Costs B *-.-- % part
Dince we are operatin at )-A capacity, we do not e$pect an increase in
fi$ed overhead8 this is a sun2 cost. 1e would !anufacture the parts since it
is B ".-- % part cheaper:
Purchase B 0-.-- vs. Manufacture B ,(.-- ;B &0.-- L B &+.-- L B &,.--<
E$a!ple , G /iscontinue a Product
=ou are considerin droppin product CM', fro! your product line because
the #nco!e Dtate!ent for CM', shows the followin:
Traditional Eelevant
Dales Eevenues B &-,--- B &-,---
Cost of Coods Dold ' Hariable ; *,---< ; *,---<
Cost of Coods Dold ' Fi$ed ; ",---<
:peratin E$penses ' Hariable ; ",0--< ;",0--<
:peratin E$penses ' Fi$ed ; *--<
#nco!e ;Koss< B ; &,&--< B &,0--
Conclusion: 1e should continue sellin CM', since it earns B &,0-- of
#nco!e.
E$a!ple 0 G Accept a Dpecial :ffer
A custo!er has offered you B &0.-- for 0,--- units of your product. =ou
nor!ally sell your product for B "0.--. Dhould you accept this offerJ
=ou currently produce and sell ,-,--- units with a !a$i!u! capacity of
0-,--- units. Total !anufacturin costs are B &(.-- per unit, consistin of B
&".0- variable and B 0.0- fi$ed.
Chane in Eevenues B )0,--- ;0,--- $ B &0.--<
+
Chane in E$penses ; *",0--< ;0,--- $ B &".0-<
>et Chane B &",0--
Conclusion: =ou should accept the special offer since it results in B &",0--
of additional inco!e.
Do far, we have covered present values and relevancy within capital
budetin. 1e now can proceed to calculate the present value of relevant
cash flows. :nce we have deter!ined the present value of cash flows, we will
have a basis for co!parin our initial invest!ent. 7oth values ;future cash
flows and initial invest!ent< will be e$pressed in current values. The net of
these two a!ounts will tell us how !uch value we will create or destroy by
investin in a pro5ect.
E$a!ple * G Calculate Eelevant Cash Flows for Capital Pro5ect
1e plan on purchasin a new asse!bly !achine for B "0,---.. #t will cost B
",--- to have the new !achine installed and we e$pect a B &,--- net
increase in wor2in capital. 7y !a2in the invest!ent, we will reduce our
annual operatin costs by B ),--- and we e$pect to save B 0-- a year in
!aintenance. The new !achine will re3uire B )0- each year for technical
support. 1e will depreciate the !achine over 0 years under the straiht'line
!ethod of depreciation with an e$pected salvae value of B 0,---. The
effective ta$ rate is .0A.
Annual Davins in :peratin Costs B ),---
Annual Davins in Maintenance 0--
Annual Costs for Technical Dupport ; )0-<
Annual /epreciation ; ,,---< N
Eevenues B ",)0-
Ta$es O .0A ; +*"<
>et Pro5ect #nco!e &,)((
Add 7ac2 /epreciation ;noncash ite!< ,,---
Relevant Proect Cash !lo" # $%&''
N B "0,--- ' B 0,--- % 0 years I B ,,---
1e will receive B 0,)(( of cash flow each year by investin in this new
asse!bly !achine. Dince we have a salvae value, we have a ter!inal cash
flow associated with this pro5ect.
E$a!ple ) G Calculate Ter!inal Cash Flow for Capital Pro5ect
Esti!ated Dalvae A!ount in 0 =ears B 0,---
Kess Ta$es ;&,)0-<
,
Terminal Cash !lo" # (%)$*
Calculating the Present -alue of Cash "lo#s
:ur ne$t step is to calculate present values of our two cash flow strea!s. 1e
will use our cost of capital to discount the cash flows. 1e will assu!e that our
cost of capital is &"A. 1e will use the present value tables in E$hibits & and "
for findin the appropriate discount factor per the life of our cash strea!s and
the &"A cost of capital.
E$a!ple ( G Calculate Present Halue of Cash Flows
Annual Pro5ect Cash Flows B 0,)((
/iscount Factor per E$hibit " $ ..*-0 ;&<
Present Halue of Annual Flows B "-,(**
Ter!inal Cash Flow B .,"0-
/iscount Factor per E$hibit & $ .0*) ;"<
Present Halue of Ter!inal Flow &,(,.
Total Present +alue # ))%&*,
;&<: 1e use the Annuity Table since we have the sa!e cash flows each year for the ne$t 0
years. #f we loo2 at E$hibit " for n I 0 years and &"A, we find ..*-0
;"<: 1e need to discount the ter!inal cash flow received five years fro! now to the present by
usin the Present Halue Table in E$hibit &.
Calculating .et /nvest0ent
>ow that we have the current value of B "",)-+ for our cash flows, we need
to co!pare this to our invest!ent a!ount. :ur invest!ent is the total cash
outlay we !ust !a2e today and it includes:
All cash paid out to invest in the pro5ect and place it into service, such as installation,
transportation, etc.
>et proceeds fro! the disposal of any old e3uip!ent that will be replaced by the new
e3uip!ent.
Any ta$es paid and%or ta$ benefits received fro! !a2in the invest!ent.
1
E$a!ple + G Calculate >et #nvest!ent
Eeferrin bac2 to E$a!ple *, we can calculate our >et #nvest!ent. 1e will
also assu!e that an e$istin !achine can be sold for B *,---.
Ac3uisition Costs B "0,---
#nstallation Costs ",---
#ncrease in 1or2in Capital &,---
Proceeds fro! Dale B *,---
Kess Ta$es O .0A ;",&--<
>et Proceeds fro! Dale ;.,+--<
-et Investment # ).%/**
Do we now have a current value for our cash flows of B "",)-+ and a total net
invest!ent of B ",,&--. These a!ounts are derived by loo2in at three
different types of cash flows:
&. Eelevant cash flows durin the life of the pro5ect.
". Ter!inal cash flows at the end of the pro5ect.
.. #nitial cash flows ;net invest!ent<.
Three Econo0ic Criteria for Evaluating
Capital Pro&ects
1e have co!pleted our three !ain staes of capital budetin analysis,
includin the calculation of discounted cash flows. The ne$t step is to apply
so!e econo!ic criteria for evaluatin the pro5ect. 1e will use three criteria:
>et Present Halue, Modified #nternal Eate of Eeturn, and /iscounted
Paybac2 Period.
.et Present -alue
The first criterion we will use to evaluate capital pro5ects is >et Present Halue.
>et Present Halue ;>PH< is the total net present value of the pro5ect. #t
Chapter
3
12
represents the total value added or subtracted fro! the orani6ation if we
invest in this pro5ect. 1e can refer bac2 to our previous e$a!ple and
calculate >et Present Halue.
E$a!ple &- G Calculate >et Present Halue
>et #nvest!ent :utflow ;E$a!ple +< B ;",,&--<
Present Halue of #nflows ;E$a!ple (< "",)-+
-et Present +alue # 0/%(,/1
#f the >et Present Halue is positive, we should proceed and !a2e the
invest!ent. #f the >et Present Halue is neative ;as is the case in E$a!ple
&-<, then we would not !a2e the invest!ent.
3odified /nternal )ate of )eturn
7esides deter!inin the >et Present Halue of a pro5ect, we can calculate the
rate of return earned by the pro5ect. This is called the #nternal Eate of Eeturn.
#nternal Eate of Eeturn ;#EE< is one of the !ost popular econo!ic criteria for
evaluatin capital pro5ects since !anaers can identify with rates of return.
#nternal Eate of Eeturn is calculatin by findin the discount rate whereby the
>et #nvest!ent a!ount e3uals the total present value of all cash inflows8 i.e.
>et Present Halue I -. #f we have e3ual cash inflows each year, we can solve
for #EE easily.
E$a!ple && G Calculate #nternal Eate of Eeturn
Eeferrin bac2 E$a!ple *, we would solve for #EE as follows:
B 0,)(( $ discount factor I B ",,&-- or B ",,&-- % B 0,)(( I ,.&*,.
#f we loo2 in the Present Halue Tables for n I 0 years, we want to find a
present value factor nearest to ,.&*,. 7y referrin to published present
value tables, we find the followin:
At *A, n I 0 ,."&", ,."&",
As Calculated ,.&*,-
At )A, n I 0 ,.&--"
/ifference .-,(, .&&""
.-* L ;.-,(, % .&&""< $ ;.-) ' .-*< I .-*,.
11
Internal Rate of Return 2 34.(5
#f the #nternal Eate of Eeturn were hiher than our cost of capital, then we
would accept this pro5ect. #n our e$a!ple, the #EE ;*.,.A< is less than our
cost of capital ;&"A<. Therefore, we would not invest in this pro5ect.
:ne of the proble!s with #EE is the so'called reinvest!ent rate assu!ption.
#EE !a2es the assu!ption that every year you will be able to earn the #EE
each ti!e you reinvest your cash inflows. This assu!ption can result in so!e
!a5or distortions between >et Present Halue and #nternal Eate of Eeturn. 1e
will correct this distortion by !odifyin our #EE calculation.
E$a!ple &" G #EE /istortions fro! Eeinvest!ent Eate Assu!ption
A summary of four simple projects with I and !"#$
Cash #nflows
Pro5ect #nvest!ent =ear'& =ear'" #EE >PH
A B ",--- B ' - ' B ,,0-- 0-A B .,&.-
7 ",--- &,0-- ","0- 0-A ",(&-
C ",--- ",,0- &,--- 00A ",*,-
/ ",--- ' - ' ,,"&- ,0A ",+,-
#f we use #EE, we would select Pro5ect C, but if we o by >PH, we would
select Pro5ect A.
#n order to eli!inate the reinvest!ent rate assu!ption, we will !odify the
#nternal Eate of Eeturn so that the reinvest!ent rate is our cost of capital.
This will ive us a !ore accurate #EE for our pro5ect. Fortunately, we can use
spreadsheets li2e Microsoft E$cel to calculate Modified #nternal Eate of
Eeturn.
E$a!ple &. G Calculate Modified #EE Fsin Microsoft E$cel
Eeferrin bac2 to E$a!ple *, we have the followin:
B 0,)(( annual pro5ect cash inflows
B ",,&-- net invest!ent a!ount
&"A cost of capital
The for!ula for calculatin Modified #EE in a Microsoft E$cel Dpreadheet is:
OM#EE;A&:An, 2A, rA<
A&:An is the cell rane for enterin our data. 1e always enter the net
invest!ent in the first cell and the cash inflows in each cell thereafter. 2A
1!
refers to our cost of capital and rA is the rate we believe we can earn when
we reinvest cash inflows.
#f we assu!e that we can earn our cost of capital on reinvested cash flows,
then we would enter the followin fro! our e$a!ple:
Cell #nput :utput
A& '",,&--
A" 0,)((
A. 0,)((
A, 0,)((
A0 0,)((
A* 0,)((
7& OM#EE;A&:A*, &"A, &"A< +A
The Modified #EE on our pro5ect is +A.
iscounted Pay4ac5 Period
The final econo!ic criteria we will use is the /iscounted Paybac2 Period.
Paybac2 refers to the nu!ber of years it ta2es to recover our net invest!ent.
#n our previous e$a!ple ;E$a!ple *<, we could use a si!ple paybac2
calculation as follows:
B ",,&-- % B 0,)(( I ,." years
However, this !ethod does not reconi6e the ti!e value of !oney and as we
previously indicated, we !ust consider the ti!e value of !oney because of
inflation, uncertainty, and opportunity costs. Therefore, we will use the
discounted cash flows to calculate the paybac2 period ;discounted paybac2
period<.
E$a!ple &, G Calculate /iscounted Paybac2 Period
Eeferrin bac2 to E$a!ple *, we can calculate the discounted paybac2
period as follows:
=ear Cash Flow $ P.H. Factor I P.H. Cash Flow Total to /ate
& B 0,)(( .(+. B 0,&*+ B 0,&*+
13
" 0,)(( .)+) ,,*&. +,)("
. 0,)(( .)&" ,,&"& &.,+-.
, 0,)(( .*.* .,*(& &),0(,
0 0,)(( .0*) .,"(" "-,(**
0 .,"0- .0*) &,(,. "",)-+
Fnder the /iscounted Paybac2 Period, we would never receive a paybac2 on
our pro5ect8 i.e. the total to date present cash flows never reached B ",,&--
;net invest!ent<. #f we had relied on the reular paybac2 calculation, we
would falsely assu!e that this pro5ect does paybac2 in the fourth year.
#n su!!ary, we use econo!ic criteria that have realistic econo!ic
assu!ptions about capital invest!ents. Three econo!ic criteria that !eet
this test are:
>et Present Halue
Modified #nternal Eate of Eeturn
/iscounted Paybac2 Period
1$
Additional Considerations in Capital
Budgeting Analysis
1henever we analy6e a capital pro5ect, we !ust consider uni3ue factors. A
discussion of all of these factors is beyond the scope of this course. However,
three co!!on factors to consider are:
Co!pensatin for different levels of ris2s between pro5ects.
Eeconi6in ris2s that are specific to forein pro5ects.
Ma2in ad5ust!ents to capital budetin analysis by loo2in at the actual results.
Ad&usting for )is5
1e previously learned that we can !anae uncertainty by initiatin decision
analysis and buildin options into our pro5ects. 1e now want to turn our
attention to !anain ris2s. #t is worth notin that uncertainty and ris2 are not
the sa!e thin. Fncertainty is where you have no basis for a decision. Eis2 is
where you do have a basis for a decision, but you have the possibility of
several outco!es. The wider the variation of outco!es, the hiher the ris2.
#n our previous e$a!ple ;E$a!ple *<, we used the cost of capital for
discountin cash flows. :ur e$a!ple involved the replace!ent of e3uip!ent
and carried a low level of ris2 since the e$pected outco!e was reasonably
certain. Duppose we have a pro5ect involvin a new product line. 1ould we
still use our cost of capital to discount these cash flowsJ The answer is no
since this pro5ect could have a !uch wider variation in outco!es. 1e can
ad5ust for hiher levels of ris2 by increasin the discount rate. A hiher
discount rate reflects a hiher rate of return that we re3uire whenever we
have hiher levels of ris2.
Another way to ad5ust for ris2 is to understand the i!pact of ris2 on outco!es.
Densitivity Analysis and Di!ulation can be used to !easure how chanes to
a pro5ect affect the outco!e. Densitivity analysis is used to deter!ine the
chane in >et Present Halue iven a chane in a specific variable, such as
esti!ated pro5ect revenues. Di!ulation allows us to si!ulate the results of a
pro5ect for a iven distribution of variables. 7oth sensitivity analysis and
si!ulation re3uire a definition of all relevant variables associated with the
pro5ect. #t should be noted that sensitivity analysis is !uch easier to
Chapter
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1%
i!ple!ent since sophisticated co!puter !odels are usually re3uired for
si!ulation.
/nternational Pro&ects
Capital invest!ents in other countries can involve additional ris2s. 1henever
we invest in a forein pro5ect, we want to focus on the values that are added
;or subtracted< to the Parent Co!pany. This !a2es us consider all relevant
ris2s of the pro5ect, such as e$chane rate ris2, political ris2, hyper'inflation,
etc. For e$a!ple, the discounted cash flows of the pro5ect are the discounted
cash flows of the pro5ect to the forein subsidiary converted to the currency of
the ho!e country of the Parent Co!pany at the current e$chane rate. This
forces us to ta2e into account e$chane rate ris2s and its i!pact to the Parent
Co!pany.
Post Analysis
:ne of the !ost i!portant steps in capital budetin analysis is to follow'up
and co!pare your esti!ates to actual results. This post analysis or review
can help identify bias and errors within the overall process. A for!al trac2in
syste! of capital pro5ects also 2eeps everyone honest. For e$a!ple, if you
were to announce to everyone that actual results will be trac2ed durin the life
of the pro5ect, you !ay find that people who sub!it esti!ates will be !ore
careful. The purpose of post analysis and trac2in is to collect infor!ation that
will lead to i!prove!ents within the capital budetin process.
Course Su00ary
The lon'ter! invest!ents we !a2e today deter!ines the value we will have
to!orrow. Therefore, capital budetin analysis is critical to creatin value
within financial !anae!ent. And the only certainty within capital budetin is
uncertainty. Therefore, one of the biest challenes in capital budetin is to
!anae uncertainty. 1e deal with uncertainty throuh a three'stae process:
&. 7uild 2nowlede throuh decision analysis.
". Eeconi6e and encourae options within pro5ects.
.. #nvest based on econo!ic criteria that have realistic econo!ic assu!ptions.
:nce we have co!pleted the three'stae process ;as outlined above<, we
evaluate capital pro5ects usin a !i$ of econo!ic criteria that adheres to the
principles of financial !anae!ent. Three ood econo!ic criteria are >et
Present Halue, Modified #nternal Eate of Eeturn, and /iscounted Paybac2.
1*
Additionally, we need to !anae pro5ect ris2 differently than we would
!anae uncertainty. 1e have several tools to help us !anae ris2s, such as
increasin the discount rate. Finally, we want to i!ple!ent post analysis and
trac2in of pro5ects after we have !ade the invest!ent. This helps eli!inate
bias and errors in the capital budetin process.
"inal Exa0
Delect the best answer for each 3uestion. E$a!s are raded and ad!inistered over the
internet at www.e$inf!.co!%trainin.
&. Capital budetin analysis consists of three distinct staes. The first stae is:
a. /iscounted Cash Flows
b. Di!ulation
c. /ecision Analysis
d. >et Present Halue
". The ability to postpone, delay, alter or abandon a pro5ect adds value to the pro5ect. This
value is referred to as:
a. Eelevant cash flows
b. Attribute value
c. >et Present Halue
d. :ption Pricin
.. The ti!e value of !oney is i!portant for three reasons. These three reasons are:
a. #nflation, uncertainty, and opportunity costs.
b. Eelevancy, stability, and consistency.
c. Pro5ect returns, costs, and ti!in.
d. Pro5ect options, positions, and variables.
,. 1hich of the followin is relevant in deter!inin the cash flows of a pro5ectJ
a. Dun2 costs
b. /epreciation
1+
c. Paybac2 period
d. >et Present Halue
0. =ou are about to invest B &0,--- into a pro5ect that will enerate B 0,0-- of cash flows
each year for the ne$t . years. #f your cost of capital is &&A, then the present value of
future cash flows is: ;refer to E$hibit " for present value tables<
a. B ".,"&(
b. B &.,,,"
c. B &&,*&"
d. B &-,(-(
*. Eeferrin bac2 to 3uestion 0, the >et Present Halue of the pro5ect is:
a. B *,,&(
b. B (,"&(
c. B ;&,00(<
d. B ;,,&+"<
). =ou are considerin investin in a new cotton'bailin !achine. The purchase price of
new bailer is B &-,---. #t will cost B )0- to transport the bailer to your location. The old
bailer will be sold for B ",--- and your ta$ rate is ,-A. The net invest!ent for this pro5ect
is:
a. B &&,+0-
b. B &-,)0-
c. B +,00-
d. B (,+0-
(. #n addition to usin >et Present Halue to evaluate a pro5ect, another ood econo!ic
criteria that can be used is:
a. Accountin Eate of Eeturn
b. Modified #nternal Eate of Eeturn
c. Di!ple Paybac2
1,
d. Eeturn on #nvest!ent
+. :ne !ethod for !anain pro5ect ris2 is to use:
a. Densitivity Analysis
b. /iscounted Paybac2
c. >et #nvest!ent
d. Pro5ect Turnover
&-. An additional ris2 usually associated with an international pro5ect is:
a. Pro5ect paybac2
b. /irect Kabor Chanes
c. #nstallation Costs
d. Forein E$chane Eate Eis2
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