Capital Budgeting Problem

MBA612, Dr. Schieuer

By: Dean Anderson, Terry Sutton,

Sawan Tamang, Karuna Mishra,

2 Capital Budgeting Process: Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures (Sullivan & Sheffrin, 2003). The capital budgeting process involves three basic steps: 1. Identify potential investments 2. Evaluate the set of opportunities, choosing those that create shareholder value, prioritize 3. Implement and

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Mutually exclusive projects – When two project’s offer IRR’s in excess of the hurdle rate, but the firm can invest in only one, the answer is not always the obvious one, the one with the highest IRR.

Profitability index (PI) – Compute the present value of a firm’s cash inflows for the years of the project and then divide by the initial cash outflow to obtain the PI. Accept the project if the PI exceeds one (1).

Cash flow analysis helps us determine just what a project’s relevant cash flows will be – that is, the inputs for the capital budgeting decision tools, focusing on which cash flows one should include when calculating a project’s NPV. A capital budgeting problem will have time zero initial investment cash flows, operating life cash flows, and terminal period end of project cash flows, because we are interested in the cash flow consequences of investments we must understand which cash flows to include. 4

Initial cash outflow for a project – The acquisition of a fixed asset and it’s tax credit, the after taxes salvage value of a fixed asset if it applies, and the net working capital we add.

Sunk costs – Costs that have been incurred in the past and cannot be recovered, these are costs that have already been spent and are not recoverable.

Opportunity costs – of one investment are the cash flows on the alternative investment that the firm