Module 7

Module 7 - Capital Budgeting (Chapters Ten and Eleven)

All  page numbers are references to Corporate Finance: A Focused Approach, 5th  edition by Ehrhardt and Brigham (Cengage, 2013)

Chapter 10

Capital Budgeting Basics - Capital Budgeting Decisions are the most important decisions that are made within a company. This chapter covers the basic methods of evaluating capital budgeting projects.

Need to Absorb - How to calculate and interpret Payback method, Net Present Value, Internal Rate of Return, and Profitability Index.  Know the difference between Independent and Mutually Exclusive projects. Pay particular attention to NPV and IRR, and know why they sometimes produce different choices. Know the Reinvestment Rate assumptions for all methods. Know the strengths and weaknesses of Payback method, Net Present Value, Internal Rate of Return, Modified Internal Rate of Return, and Profitability Index.  You need to understand there are issues related to evaluating projects with Unequal Lives.  Be able to define Capital Rationing.  While unlikely to be on the exam, you should know how to compute the Optimal Capital Budget. 

Do not need to absorb - How to calculate Modified Internal Rate of Return or how to calculate and interpret Discounted Payback or Equivalent Annual Annuities.

Need to Read - Read the Chapter.

Need to Do - Make 100 on the quiz. Questions and Problems that you should answer- Self Test 1, Questions - All, and all end of chapter Problems related to NPV, IRR, Payback, and Profitability Index.  I consider Self-Test 1, and Problems 9-13, 15, 19 and 21 to be exam level problems.

Calculator links

Most Calculator Types

A 17 minute Youtube video demonstrating Payback, NPV, IRR, and Profitability Index when using Excel (has lots of background noise but a good overview)

1. Watch the Chapter Introduction and Overview video. The Powerpoints for all of this chapter's videos are located here.

2. Read pages 397-403.

3. Watch the Net Present Value video.  After this video, you should be able to solve problems 1 and 7a.

4. Read pages 403-413.

7. Watch the video on Internal Rate of Return, Modified Internal Rate of Return, and conflicts between NPV and IRR. After this video, you should be able to solve problems 2 and 7b.

6. Read pages 413-416.

5. Watch the video on Profitability Index, Payback, Discounted Payback, and Normal versus Nonnormal Cashflows.  After this video, you should be able to answer all of the suggested self-tests, questions, and problems.

8. Read the remainder of the chapter.

9. Not important is the last video.  Topics on this video will not be tested on exams, Projects with Unequal Lives, the Economic Life of Projects.

10. Below are audio solutions to problems of the type you will see from this chapter.

11. Be prepared for a 60 minute quiz, with about 13 questions, over chapter 10.

 

Chapter 11

Need to Absorb - The most important material is to be able to identify Relevant Cash Flows, for both new and replacement Capital Budgeting projects.  This includes calculating initial, operating, and terminal project cash flows.  This includes how to handle sunk costs, opportunity costs, depreciation, and cannibalization.  Know the basics of how to adjust for inflation (i.e. use real discount rates with real cash flows and nominal (inflation-adjusted) discount rates with nominal cash flows).  Know the major terms and brief definitions associated with measuring project risk sensitivity, scenario, break-even, and Monte Carlo simulation.  Be able to compute break-evens.  Understand the basics of computing risk adjusted Cost of Capital.  Be able to define and recognize the major real options.  Be able to compute NPV using staged decision trees (will be quizzed, may not be on exams due to time needed to solve each problem). When given information on real options, be able to identify the  type of option, who is long, who is short, the underlying asset, the exercise  price, and sometimes the premium.

Do not need to Absorb - You will not need to compute sensitivity, scenario, or Monte Carlo simulations on an exam.

Need to Read - Read the Chapter.

Need to Do - Make 100 on the quiz.  Be able to solve End of Chapter Questions 1-7 and 9-11, Problems 1-15 and 17.  The calculations in this chapter take a lot of time, so I do not expect you to solve all of the previously listed problems. However, you should review each of the problems to determine if you could solve the problem.  I consider the following problems to be exam level, 1-10, 12-14, and 17.

Calculator links: Most Calculator Types

1. Watch the Chapter Introduction and Overview video. The Powerpoints for all of this chapter's videos are located here.  I have a good handout on recognizing relevant cash flows located here.  Also, and this is more indepth than you will need, I have a handout on Real Options located here.

2. Read pages 437-450.

3. Watch the Relevant Cash Flows, Computing Initial Cash Flows and Computing Depreciation video.  After this video, you should be able to answer end of chapter questions 2-5.

4. Watch the Computing Operating Cash Flows, Terminal Cash Flows and Valuing the Project video.  After this video, you should be able to answer end of chapter problems 1-3 and 5-7.

5. Read pages 450-460.

6. Watch the video on Risk in Capital Budgeting.  If you feel you understand the material from the reading, there is no reason to watch this video.

7. Read the remainder of the chapter.

8. Watch the video on Simulation Analysis and Real Options.  My discussion on real options is pretty good.  There is no discussion of decision trees, but I do have a problem below that uses a decision tree.  Identifying Real Options is a useful skill, if you are interested, watch the video on Spotting Real Options

9. Make sure you think you could solve the suggested end of chapter Questions and Problems.

10. Here are audio solutions related to the estimation of cash flows.

11. Review the remaining above suggested questions and problems. Be prepared for a 60-80 minute quiz over Chapter 11.

Updated January 30, 2016.

 

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