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09: Page 1 of 47 MODULE 09 CAPITAL BUDGETING 3. RANKING AND SELECTING CAPITAL PROJECTS Think of this module as a continuation of Module 8 because here you apply the cost of capital to ranking and selecting proposed capital projects. Module 7 discussed the first step in capital budgeting— estimating cash flows of a proposed capital investment project. Module 8 looked at the way financial managers determine the opportunity cost of capital invested in a proposed project. Now, you will read about ranking and selecting projects to increase stock price and shareholder wealth. Consider, for example, J.C. Penney Company. Penney revenues in 2009 were about $18.5 billion. Its stock traded around $27 per share, book value per share was about 24, and its beta 1.55. Its capital budgeting committee regularly considers many investment proposals. One proposal includes opening a line of specialty apparel stores. Another, adding national brands such as Liz Claiborne to its own line of merchandise. Yet another, joining Macys and Sears to develop regional shopping centers in the northwest United States. These proposals involve largely different investments and cash flows. They range from small (adding national brands to its own line of merchandise) to large (developing regional shopping centers). How does the financial manager choose from among these proposals? The answer unfolds in this module. The module discussion begins with a short review of cash-flow analysis considered initially in Module 7. You will then see the way financial managers use cash flows in two non-discounted cash flow methods of selecting projects. The module then turns to discounted cash flow (DCF) analysis. Here, you learn that financial managers have several DCF methods available for selecting projects, each offering its own advantage over the other. The final part of the module introduces a method to include risk adjustments in the decision process. When you finish this module you will be able to do the following: 1. Measure incremental cash flows from a proposed capital project. 2. Evaluate a proposed project with two non-discounted cash flow methods, payback analysis and average rate of return; recognize weaknesses of these methods. 3. Measure and interpret internal rate of return, net present value, net present value index (profitability index), and net future value methods to evaluate a proposed project. Plot net present value profiles of proposed projects. 4. Select projects ranked in order of IRR. Determine the size of the capital budget and expected increase in stock price based on the selected projects. 5. Discuss causes and implications of a conflict in rank order of acceptable projects when ranked according to net present value and internal rate of return. 6. Know the way to resolve a conflict in rank order by selecting projects based on a comparison of calculated crossover rate and expected reinvestment rate. 7. Calculate a risk-adjusted discount rate for use in evaluating risky projects.
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This note was uploaded on 05/10/2010 for the course FINA 3770 taught by Professor Chandy during the Fall '08 term at North Texas.

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