CAPITAL BUDGETING

CHOOSING THE RIGHT PROJECTS

The Goals of a Firm

Remember: The primary
Capital budgeting: Using discounted cash flow analysis to financial goal of a firm is to
determine which long-term investments are the best use of a increase shareholder wealth.
company’s capital.
Stakeholders: Parties with an interest in a firm, including
Shareholder goals include:
shareholders, employees, suppliers, customers, local
Maximizing wealth and firm
communities, and more.
profits, managing risks to
Wealth: The present value of all future economic benefits wealth, and transforming
less costs of the assets owned by an entity. wealth to consumption at will.

The Net Present Value Rule

Net present value rule: A company should invest in all If independent projects are
independent projects with a positive net present value mutually exclusive, the
(NPV). company should invest in the
project with the highest NPV.
Opportunity cost: The foregone benefits of the next best
alternative use of a company’s available resources.
Opportunity cost of capital: The return an investor could The opportunity cost of capital
earn from another investment with the same level of risk. is the discount rate used in
NPV calculations. It is often set
Sunk cost: Past costs that cannot be recovered. equal to the weighted average
Sunk costs are irrelevant to capital budgeting. cost of capital (WACC).
Salvage value: The resale value of a project’s property, plant
and equipment at the end of its useful life.
Widgets-to-Wadgets
Marginal cash flows: Future cash flows resulting from the Project Analysis
firm moving forward with a particular course of action.
Year 1
Incremental cash flows: Future cash flows that occur only if Project Revenue 75,000
a project is chosen for investment. Project Expenses (150,000)
Depreciation expense should be treated as a cash flow to Cost Savings 150,000
calculate the tax expense of the project and then removed Opportunity Costs 0
afterwards. Depreciation (out) (35,000)
Taxable Earnings 40,000
Tax (10,000)
Earnings After Tax 30,000
Depreciation (in) 35,000
Working Capital 5,000
Net Cash Flows 70,000

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CAPITAL BUDGETING

Other Capital Budgeting Metrics

Internal rate of return (IRR): The discount rate that results in
an NPV of $0.

If IRR is below the required rate of return, NPV will be

negative.

If IRR is above the required rate of return, NPV will be

positive.
Remember: The payback
Payback period: The amount of time required for a project to period does not account for
recoup its initial investment. the time value of money.
Unless mutually exclusive projects have the same NPV,
the NPV rule should be the primary method of selection
between projects.

Accounting for Uncertainty

Uncertainty: A range of possible outcomes.
Monte Carlo simulations
Sensitivity analysis: Describes how NPV is affected by a require the following input:
change in a critical variable. The possible values of
Break-even analysis: Calculates how many unit sales are each critical variable, the
required for a project to break even with an NPV of $0. probability of those values,
and the correlations between
Monte Carlo simulations: Compute possible outcomes of a each pair of variables.
project with the likelihood that they will happen.

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