Chapter 13 Capital Budgeting, Risk Considerations, and Other Special Issues

Notes

13.1 Capital Expenditures

The Importance of the Capital Expenditure Decision

•capital expenditures a firm’s investments in long-lived assets, which may be tangible or intangible

•long-term investment decisions determine a company’s future direct and could be viewed as most important decisions a firm can

make, because a firm’s capital expenditures (capex) usually involve large amounts of money, and decisions are often irrevocable

•the importance of capex decisions lies in their ability to affect the risk of the firm

•capital budgeting process through which firm makes capital expenditure decisions by (1) identifying investment alternatives,

(2) evaluating alternatives, (3) implementing chosen investment decisions, and (4) monitoring and evaluating chosen decisions

•five forces the five critical factors that determine the attractiveness of an industry: entry barriers, the threat of substitutes, the

bargaining power of buyers, the bargaining power of suppliers, and rivalry among existing competitors

•Michael Porter argues that firms can create competitive advantages for themselves by adopting one of the following strategies:

cost leadership (strive to be a low-cost producer); and differentiation (offer “differentiated” products)

•cost leadership usually follows from replacement decisions, when firms are constantly striving to use the latest technology to

lower the costs of production, while product differentiation usually follows from new product development decisions

•bottom-up analysis an investment strategy in which capex decisions are considered in isolation, without regard for whether

the firm should continue in this business or for general industry and economic trends

•top-down analysis an investment strategy that focuses on strategic decisions, such as which industries or products the firm

should be involved in, looking at the overall economic picture

•discounted cash flow (DCF) methodologies techniques for making capex decisions that are consistent with the overriding

objective of maximizing shareholder wealth; they involve estimating future cash flows and comparing their discounted values

with investment outlays required today

13.2 Evaluating Investment Alternatives

Net Present Value (NPV) Analysis

•net present value (NPV) sum of present value of all future after-tax incremental cash flows generated by an initial cash outlay,

minus present value of investment outlays; present value of expected cash flows net of costs needed to generate them

•incremental in capital budgeting, the change in revenues or costs resulting from the investment decision

•cash flows that have already been incurred are referred to as “sunk” costs and are ignored, since they do not change

•risk-adjusted discount rate (RADR) a discount rate that is set based on the overall riskiness of a project

•accepting positive-NPV projects maximizes the firm’s market value and creates shareholder value

•accepting negative-NPV projects destroys firm value, and such projects should be rejected because, by definition, the destruction

of shareholder value is not in the best interests of the shareholders

The Internal Rate of Return (IRR)

•internal rate of return (IRR) the discount rate that makes the present value of future cash flows equal to the initial cash outlay

•the general rule for IRR evaluation criteria is that a firm should accept a project whenever the IRR is greater than the appropriate

risk-adjusted discount rate (k), which is usually the firm’s cost of capital

•when IRR is greater than k, the NPV will be positive because the PV will be higher when using a lower discount rate (i.e., k)

than it will be when using the higher discount rate (i.e., IRR)

•a positive NPV implies that a project earns a return (IRR) that is higher than the cost of funds (which is reflected in k)

A Comparison of NPV and IRR

•mutually exclusive projects situation in which acceptance of one project precludes acceptance of one or more other projects

•crossover rate a special discount rate at which the net present value profiles of two projects cross

Issue NPV IRR

1. Future cash flows change sign NPV still works the same for both

accept/reject and ranking decisions.

Multiple IRRs may result—in this case,

the IRR cannot be used for either accept/

reject or ranking decisions.

2. Ranking projects Higher NPV implies greater contribution

to firm wealth—it is an absolute measure

of wealth.

The higher IRR project may have a lower

NPV, and vice versa, depending on the

appropriate discount rate and the size of

the project.

3. Reinvestment rate assumed for future Assumes all future cash flows are Assumes cash flows from each project are

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## Document Summary

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