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
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.
Use the following information to answer questions a-e. You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is $177,000, and shipping costs will be $3,500. It will cost another $26,600 to modify it for special use by your firm, and an additional $12,400 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after three years for $22,000. The equipment is expected to generate revenues of $173,000 per year with annual operating costs of $81,000. The firm's tax rate is 30.0%. Here is the MACRS depreciation schedule, Year 1=33%, Year 2=45%, Year 3=15%, Year 4= 7%.
a.What is the net investment (initial outlay) for the project?
b.What is the operating cash flow for year 1?
c.What is the operating cash flow for year 2?
d.What is the operating cash flow for year 3?
Use the following information to answer questions f-j. You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is $195,000, and shipping costs will be $3,900. It will cost another $23,400 to modify it for special use by your firm, and an additional $9,800 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after three years for $30,200. The equipment is expected to generate revenues of $179,000 per year with annual operating costs of $90,000. The firm's tax rate is 25.0%. Here is the MACRS depreciation schedule, Year 1=33%, Year 2=45%, Year 3=15%, Year 4= 7%.
f. What is the net investment (initial outlay) for the project?
g. What is the operating cash flow for year 1?
h. What is the operating cash flow for year 2?
i. What is the operating cash flow for year 3?
m. Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the accounting break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%.The Audio link is here.
n. Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the economic break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%.The Audio link is here.
o. Hit or Miss Sports is introducing a new product this year. If its see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%. a. If each outcome is equally likely, what is expected NPV? Will the firm accept the project? b. Suppose now that the firm can abandon the project and sell off the manufacturing equipment for $5.4 million if demand for the balls turns out to be weak. The firm will make the decision to continue or abandon after the first year of sales. Does the option to abandon change the firm's decision to accept the project?The Audio link is here.
p. Hit or Miss Sports is introducing a new product this year. If its see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%. a. If each outcome is equally likely, what is expected NPV? Will the firm accept the project? b. Now suppose that Hit or Miss Sports from the previous problem can expand production if the project is successful. By paying its workers overtime, it can increase production by 25,000 units; the variable cost of each ball will be higher, however, equal to $35 per unit. By how much does this option to expand production increase the NPV of the project?The Audio link is here.
11. Review the remaining above suggested questions and problems. Be prepared for a 60-80 minute quiz over Chapter 11.
Updated January 30, 2016.