Chapter 11 Capital Budgeting

Chapter 11 Capital Budgeting - Arizona State University...

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Arizona State University FINANCE 300 Fundamentals of Finance Chapter 11: Basics of Capital Budgeting Instructor: Christian Ramirez Introduction In this chapter you will be able to further apply the TVM concepts you learned in Chapter 2. Hence, if you have a clear understanding of the TVM concepts studied in Chapter 2, this chapter will be relative easy to understand. This chapter will also give you the opportunity to reinforce the TVM concepts. In Chapter 10, we discussed how companies determine their cost of capital. In this chapter, we will see how companies use capital to budget for long-term investment projects and how these projects are ranked based on the amount of value they promise to add to a company. We will also learn under what circumstances certain investment projects are selected over other projects considered by a company. Therefore, the goal of this chapter is to introduce you to the techniques used to analyze potential investment projects to decide which are worth undertaking. We will present and contrast a number of different techniques and procedures used in practice to analyze investment projects. We will also discuss the advantages and disadvantages of the various approaches and techniques used in capital budgeting. Capital Budgeting What is Capital Budgeting? Capital budgeting is the planning process used to determine a company’s long term investments on assets such as new products, new plants, and other investment projects. Companies must remain competitive if they want to survive and maintain their presence in the marketplace. This force firms to come up with long term investment projects that promise a rate of return greater then the project’s cost of capital or hurdle rate with the purpose of creating value to the stockholders. Capital budgeting allows companies like Ford or Toyota determine if they should mass produce some of their concept cars for example. Think about this for a moment, what would make Ford or Toyota decide whether producing and marketing a concept car would be a good investment. Well, many factors go into making this decision, but before any of these two car makers decide to market a new car model, they must determine how much the car is going to cost, how many years it will take to brake-even, what the price of the new car should be, the year when first sales are expected to occur and the number of years the car will be manufactured. Ford or GM would use the Capital Budgeting techniques that we will go over in this chapter to respond to these questions.
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2 The following techniques are primarily used in capital budgeting and will be thoroughly discussed in this chapter: 1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) 3. Payback Period. 4. Discounted Payback Period Net Present Value We have learned that the main goal of a financial manager or the management of a company is to create or maximize value for the stockholders of the company. Therefore,
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This note was uploaded on 12/16/2009 for the course FIN 300 taught by Professor Olander during the Spring '08 term at ASU.

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Chapter 11 Capital Budgeting - Arizona State University...

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