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Chapter 13

Chapter 13 Notes


Department
Finance
Course Code
MGFB10H3
Professor
Derek Chau
Chapter
13

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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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