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1. Introduction to Capital Budgeting
   1. What is capital budgeting? Capital budgeting is the process of planning expenditures that have a life longer than one year, such as plant and equipment. Due to the length of most capital budgeting projects, a capital budgeting decision is one of the most significant that financial managers make.
   2. Administrative Considerations.The four steps that must be taken in the capital budgeting decision process are: ____, ____, ____ and ____( Critical Concept ). See Slide 2 (32.0K) .
   3. Accounting Flows vs Cash Flows. Capital budgeting analysis uses cash flows rather than accounting flows. This is because, on the income statement, depreciation is a ____ expense( Critical Concept ). It must be added back to net income to get the correct cash flow generated.
   4. Choosing Capital Projects. Capital budgeting analysis used the concept of present value to estimated cash flows from a capital project back to the future in order to determine if the project is a worthwhile investment in present value terms. See Slide What is Capital Budgeting? (55.0K)
2. Methods of Ranking Investment Projects
   1. Payback Period. The payback period for a project is ____( Critical Concept ). The payback method is not theoretically sound, as it does not consider the time value of money. It can, however, give the financial manager an idea of when the project will generate enough in cash flows in order to recover the investment in the project. See Slide Payback Method (55.0K) . Two advantages of using the payback method are _____ and _____( Critical Concept ). Usually firms have a cut-off payback period. They do not accept projects that take longer than that cutoff period to return the initial investment. The decision rule for payback period is usually to accept projects with a shorter payback period than the cutoff and reject projects with a longer payback period. Take a look at the example of payback period and the calculation at this website.
   2. Internal Rate of Return (IRR). Calculating the internal rate of return for a capital project is simply calculating the yield on the project much like you would for a bond. The definition of internal rate of return is ______( Key Term ). For a project that generates cash flows that are an uneven stream, you should use the trial and error procedure in your textbook to approximate the IRR. If the IRR were greater than the firm's cost of capital, you would accept the project. If it were less than the firm's cost of capital, you would reject the project. See Slide Internal Rate of Return (48.0K) .
   3. Net Present Value (NPV). The most theoretically sound of these three methods of ranking investment projects is the net present value method. In order to calculate the net present value for a project, you must discount the cash inflows from the project back to the present and compare them to the initial investment. If the NPV is greater than zero dollars, you would _____ the project( Critical Concept ). If it were less than zero, you would not accept the project. You can find more explanation of net present value at this website. See Slide Net Present Value (46.0K) . See Slide Accept/Reject Decision (59.0K) for a summary of accept/reject decisions based on these methods of ranking investment alternatives. Since the most theoretically correct method of capital budgeting is net present analysis, always accept the project with the positive NPV. This decision rule should override both payback period and internal rate of return.
   4. Reinvestment Rate Assumption. One of the reasons that net present value is a superior decision criterion to internal rate of return is the reinvestment rate assumption. This assumption says that cash flows generated by a project and analyzed by the IRR method should be reinvested at the project's IRR. However, the reinvestment rate also says that if you use the NPV method, cash flows should be reinvested at _____( Critical Concept ). See Slide 9 (31.0K) and Slide 10 (34.0K) .
3. Other Considerations in Capital Budgeting
   1. What is capital rationing? Capital rationing is the process of placing a _____ constraint on projects a firm can accept( Key Term ). Only projects that fall within the budgetary constraint can be accepted. Under the net present value method, all projects with a net present value greater than zero should be accepted, however.
   2. Net present value profile. The net present value profile graphically depicts the net present value of a project at different interest rates. See Slide Net Present Value Profile (50.0K) .
4. The Steps in Analyzing a Capital Project
   1. New Project. There are three steps that a financial manager takes in analyzing a new capital project. They are depicted in Slide Determining Whether to Purchase a Machine (57.0K) .
   2. Replacement Project. If the financial manager is attempting to replace an old project (for example, an old piece of equipment) with a new project, then there are other considerations such as the sale of the old asset, the difference in depreciation between the two projects and cost savings that will be generated by the replacement project.