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CHAPTER 13




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13 - 1 Copyright © 2002 Harcourt, Inc. All rights reserved. Should we build this plant? CHAPTER 13 The Basics of Capital Budgeting: Evaluating Cash Flows 13 - 2 Copyright © 2002 Harcourt, Inc. All rights reserved. What is capital budgeting? nAnalysis of potential additions to fixed assets. nLong-term decisions; involve large expenditures. nVery important to firm’s future. 13 - 3 Copyright © 2002 Harcourt, Inc. All rights reserved. Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC. 13 - 4 Copyright © 2002 Harcourt, Inc. All rights reserved. What is the difference between independent and mutually exclusive projects? Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. 13 - 5 Copyright © 2002 Harcourt, Inc. All rights reserved. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river. 13 - 6 Copyright © 2002 Harcourt, Inc. All rights reserved. Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine. 13 - 55 Copyright © 2002 Harcourt, Inc. All rights reserved. n If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. 13 - 56 Copyright © 2002 Harcourt, Inc. All rights reserved. Capital Rationing nCapital rationing occurs when a company chooses not to fund all positive NPV projects. nThe company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. (More...) 13 - 57 Copyright © 2002 Harcourt, Inc. All rights reserved. Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital. (More...) 13 - 58 Copyright © 2002 Harcourt, Inc. All rights reserved. Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. (More...) 13 - 59 Copyright © 2002 Harcourt, Inc. All rights reserved. Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.






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