CHAPTER 2
CAPITAL BUDGETING
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1. Introduction
Copyright © 2013 CFA Institute 2
Page 49
Copyright © 2013 CFA Institute 3
Classifying Projects
Principles
• Decisions are based on cash
flows, not accounting income.
• The timing of cash flows is
crucial; that is, the time value of
money is important.
• Cash flows are incremental; that
is, cash flows are based on
opportunity costs.
• Cash flows are on an aftertax
basis because cash flows related
to taxes (payments or benefits)
are part of the cash flows that
must be analyzed.
• Financing costs are ignored in
the cash flow analysis. Financing
costs enter the decision making
through the required rate of
return.
What is conventional?
• Only one sign change.
• No cash flow (e.g., $0) is not
viewed as a sign change.
Slide 8 CONVENTIONAL AND NONCONVENTIONAL LOS: Describe the basic
CASH FLOWS
Nonconventional Cash Flow Patterns
principles of capital budgeting,
Today

1

2

3

4

5

including cash flow estimation.
Pages 51–52
     
Project Sequencing
• Capital sequencing is a situation
in which one project’s acceptance
is conditional on another project’s
success.
• Capital sequencing is, essentially,
when a project includes an option
on future, related projects.
• Example: An entertainment
company may release a
children’s movie, but wait
to introduce the related toy
line until the performance
of the movie is assessed.
Slide 11 LOS: Explain how the
CAPITAL RATIONING
• Capital rationing is when the amount of expenditure for capital projects in a
evaluation and selection of
given period is limited.
• If the company has so many profitable projects that the initial expenditures in
total would exceed the budget for capital projects for the period, the company’s
capital projects is affected by
management must determine which of the projects to select.
• The objective is to maximize owners’ wealth, subject to the constraint on the
capital budget.
mutually exclusive projects,
 Capital rationing may result in the rejection of profitable projects.
project sequencing, and capital
rationing.
Page 52
Copyright © 2013 CFA Institute 11
Capital Rationing
• Capital rationing exists when
there is a limit on how much can
be spent on capital projects.
• Capital rationing is not consistent
with owners’ wealth maximization.
• Capital rationing may be imposed
artificially (e.g., a company’s
board permits only $100 million
on capital projects per period) or
be due to capital constraints (e.g.,
credit crunch).
• Investment Decision
Criteria
Advantages
Easy to understand (i.e., value
added)
Considers the time value of money
Considers all project cash flows
Disadvantages
Result is a monetary amount, not a
return
Example: NPV
Slide 15 LOS: Calculate and interpret
EXAMPLE: NPV
0 1 2 3 4
the results using each of the
–$1,000




$200


$300


$400


$500
following methods to evaluate
a single capital project: net
present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 15
Example: NPV
Advantages
Easy to understand (i.e., return)
Considers the time value of money
Considers all project cash flows
Disadvantages
Solved iteratively
Example: IRR
Slide 18 LOS: Calculate and interpret
A NOTE ON SOLVING FOR IRR
• The IRR is the rate that causes the NPV to be equal to zero.
the results using each of the
• The problem is that we cannot solve directly for IRR, but rather must either
iterate (trying different values of IRR until the NPV is zero) or use a financial
calculator or spreadsheet program to solve for IRR.
following methods to evaluate
• In this example, IRR = 12.826%:
a single capital project: net
present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 18
Using Excel:
=IRR(B3:B7)
Payback Period
Advantages
• Easy to understand
• Considers the time value of
money
Disadvantages
Ignores cash flows beyond the
payback period
No criteria for making a decision
other than whether a project pays
back
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