### Unit 6: Capital Budgeting Techniques

This unit demonstrates how a financial manager uses financial tools to make capital investment decisions. It addresses the concept of capital budgeting and how to evaluate investment projects using the net present value calculations, internal rate of return criteria, profitability index, and the payback period method. In particular, this unit will teach you how to determine which cash flows are relevant (should be considered) when making an investment decision. For instance, suppose you have been asked to give your recommendation about buying or not buying a new building. As the financial manager, it is your task to identify cash flows that, in some way or another, affect the value of the investment (in this case, the building) and calculate whether the money spent on the project upfront is more or less than the value received. Also, this unit explains how to calculate "incremental" cash flows when evaluating a new project, which can also be considered the difference in future cash flows under two scenarios when a new investment project is being considered.

**Completing this unit should take you approximately 6 hours.**

Upon successful completion of this unit, you will be able to:

- explain the purpose of capital budgeting techniques;
- calculate the NPV, Payback, Profitability Index, and IRR of investment options;
- critique the capital budgeting methods and their effectiveness in making sound investment decisions; and
- utilize the incremental approach to make capital budgeting decisions.

### 6.1: Capital Budgeting and Net Present Value

Read this section about making capital budgeting decisions. The discussion discusses the goals of capital budgeting, how to rank investment proposals, assumptions about reinvestment, long- and short-term financing, Payback Method (PM), Internal Rate of Return (IRR), Net Present Value (NPV), and cash flow analysis. When managers and executives make financial decisions to invest limited resources, they use this information to invest more wisely.

Read this section, which discusses capital budgeting and decision-making, net present values, annuity tables, and internal rate of return. Large corporations use capital budgeting techniques when investing in real estate projects or large equipment projects.

Read this section that discusses Net Present Values (NPV), calculating and interpreting NP, and the advantages and disadvantages of using NPV. It also gives examples of how these concepts are implemented in practical applications.

### 6.2: Internal Rate of Return

Read this section about the Internal Rate of Return (IRR). Pay attention to calculating IRR, the advantages and disadvantages of using IRR, calculating multiple Internal Rates of Return, and calculating Modified Internal Rates of Return. Try the problems in this section and check your solutions.

### 6.3: Profitability Index

Read this section about capital budgeting and ranking investment proposals. These are important when businesses are comparing similar real estates investments with the intent of picking the investment that yields the highest return. This section presents several methods that are commonly used to rank investment proposals, including net present value (NPV), internal rate of return (IRR), profitability index (PI), and accounting rate of return (ARR). It also gives formulas and examples that demonstrate how to apply these formulas in the real world.

Read this section that discusses methods of evaluating capital budgeting and calculating the profitability index and modified internal rate of return (MIRR). Comparing these gives a manager a broad view of assessing the best decision for investing limited or scarce financial resources. Corporations use these capital budgeting methods when comparing and contrasting competing real estate investments that will yield variable returns.

### 6.4: Payback Period Method

Read this section on the Payback Method of investing and review the examples of how this method is used.

### 6.5: Evaluating Projects Incrementally

These videos show you how to work with a depreciating asset in an income statement. When a replacement project is being considered, the initial investment is composed of the cost of the new project plus any installation or cleaning costs minus the after-tax cash flow from selling the current project. The MACRS depreciation schedule is used to estimate the current value of a physical asset, such as a computer, at any moment of this asset's life. That value is called the "book value". When a replacement project is being considered, the incremental operating cash flows need to be computed every period starting with period 1 as follows:

incremental from the new project from the current project

When a replacement project is being considered, the terminal cash flow is the cash flow that will be generated in the last period of the project. This is an important concept when machines with a long life are intended to be used for short periods until the end of a project. After the project is over, a long-lasting machine could either be sold to a buyer at the given market price or sold as scrap for a lower amount than its remaining book value.

### Unit 6 Practice and Assessment

- Complete these exercises and problems and then check your work.