ORIE 3150
Capital Budgeting
The process of making capital expenditure decisions is known as capital budgeting.
We will focus only on
screening
decisions:
whether a proposed project meets some standard of
acceptance.
In contrast,
preference
decisions relate to selecting between several courses of
action.
This is more complicated, and will be left for other courses.
We will cover only two simple topics:
1.
Payback period
2.
Net Present Value (NPV) method
Payback Period
The payback period simply measures the number of periods necessary to recoup the original
investment. The time value of money is ignored.
Thus, it is best used for short payback periods
(like 2 years or so).
The shorter the payback period, the better.
While it is certainly not a sophisticated technique, it is easy to use.
Often businesses require that investments in costsaving devices pay for themselves in 18
months, for example.
That is, they must have a payback period of 18 months.
Net Present Value
In the majority of situations, net present value (NPV) is preferred.
NPV – the value at time zero that is the equivalent to the cash flow series of a proposed project.
We know what cash today is worth.
The value of cash flows in the future is more difficult to
assess!
NPV  Assumptions
1.
Cash flows are endofperiod, except for first costs and prepayments that occur at t = 0.
2.
Cash flows are deterministic.
Even though they occur in the future, we assume they are
known exactly.
3.
The interest rate is given.
Since this affects the NPV, choosing the appropriate rate is very
important.
4.
The problem’s time horizon, n, is given.
Usually we look at this for several years, most often
10 or more!
When to use NPV
1.
Evaluating a project when the investment is given.
The investment occurs at t = 0, and we get
future cash flows.
2.
Calculating the equivalent value for an irregular series of cash flows (usually for the sake of
comparison of several alternatives)
Salvage Value
At the end of the project horizon, we close the project and sell the assets for salvage.
Consider comparing buying a Ford Explorer vs. a Toyota 4Runner.
We consider the costs over 5 years.
But we must consider the resale value at the end of the
project horizon, 5 years.
Note, however, that the inattentive and brainless layman will attribute
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full value to the difference in salvage values.
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 Fall '08
 CALLISTER
 Net Present Value, PAYBACK PERIOD, Generally Accepted Accounting Principles

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