ch10 - 1 CHAPTER 10 The Fundamentals of Capital Budgeting...

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CHAPTER 10 The Fundamentals of Capital Budgeting Learning Objectives 1. Discuss why capital budgeting decisions are the most important investment decisions made by a firm’s management. 2. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions, and calculate the NPV for a capital project. 3. Describe the strengths and weaknesses of the payback period as a capital expenditure decision-making tool and compute the payback period for a capital project. 4. Explain why the accounting rate of return (ARR) is not recommended for use as a capital expenditure decision-making tool. 5. Compute the internal rate of return (IRR) for a capital project and discuss the conditions under which the IRR technique and the NPV technique produce different results. 6. Explain the benefits of postaudit and ongoing reviews of capital projects. I. Chapter Outline 10.1 An Introduction to Capital Budgeting A. The Importance of Capital Budgeting 1
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Capital budgeting decisions are the most important investment decisions made by management. The goal of these decisions is to select capital projects that will increase the value of the firm. Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed. Capital budgeting techniques help management to systematically analyze potential business opportunities in order to decide which are worth undertaking. B. The Capital Budgeting Process The capital budgeting process starts with a firm’s strategic plan, which spells out its strategy for the next three to five years. The process then continues with the division managers who convert the firm’s strategic objectives into business plans. The capital budget is generally prepared by the CFO’s staff and financial staffs at the divisional and lower levels. C. Sources of Information Most of the information needed to make capital budgeting decisions is generated internally, likely beginning with the sales force. The production team is then involved, followed by the accountants. All this information is then reviewed by the financial managers, who evaluate the feasibility of the project. D. Classification of Investment Projects 2
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Capital budgeting projects can be broadly classified into three types: (1) independent projects; (2) mutually exclusive projects; and (3) contingent projects. 1. Independent Projects Projects are independent when their cash flows are unrelated. If two projects are independent, accepting or rejecting one project has no bearing on the decision on the other. 2. Mutually Exclusive Projects When two projects are mutually exclusive, accepting one automatically precludes the other. Mutually exclusive projects typically perform the same function.
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This note was uploaded on 04/01/2012 for the course BUSINESS 100 taught by Professor Bens during the Spring '12 term at FIU.

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ch10 - 1 CHAPTER 10 The Fundamentals of Capital Budgeting...

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