This chapter discusses a number of practical applications of capital budgeting.
Capital budgeting must be placed on an incremental basis. This means that sunk costs must be ignored, while both opportunity costs and side effects must be considered.
In the Baldwin case, we computed NPV using the following two steps:
Calculate the net cash flow from all sources for each period.
Calculate the NPV using the cash flows calculated above.
Inflation must be handled consistently. One approach is to express both cash flows and the discount rate in nominal terms. The other approach is to express both cash flows and the discount rate in real terms. Because either approach yields the same NPV calculation, the simpler method should be used. The simpler method will generally depend on the type of capital budgeting problem.
A firm should use the equivalent annual cost approach when choosing between two machines of unequal lives.
