### Unit 3: Capital Budgeting Techniques

This unit will show you how a financial manager makes capital investment decisions using financial tools. It is especially the case that this unit 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. Say for instance, 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). Also, this unit explains how to calculate "incremental" cash flows when evaluating a new project, which can also be considered as the difference in future cash flows under two scenarios: when a new investment project is being considered and when it is not. Make sure to complete Unit 2 first before engaging in Unit 3 as this unit is considered the advanced portion using the financial techniques that are explained in Unit 2, such as the present and future value formulas.

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

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

- summarize the rules in capital budgeting when using net present value calculations;
- use the incremental approach in finance to compare the net present value of a project with the net present value of another project;
- calculate the depreciation expense of an asset and demonstrate how that expense factors into the income statement and cash flow statement; and
- calculate the net present value of an investment option

### 3.1: Capital Budgeting and Net Present Value

This section discusses Net Present Values, calculating NPV, interpreting NPV, advantages and disadvantages of using NPV, and NPV profiles. It also gives examples and discusses how to implement them.

### 3.2: Internal Rate of Return

Read this section about Internal Rate of Return (IRR).

### 3.3: Profitability Index

Read this section, which discusses capital budgeting and ranking investment proposals. These are important when businesses compare similar real estate 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).

This section discusses methods of evaluating capital budgeting and calculating the profitability index and modified internal rate of return (MIRR). It compares two separate investment proposals that give a broad view of how to evaluate 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.

### 3.4: Payback Period Method

Read this section, which presents the payback method of investing.

### 3.5: Evaluating Projects Incrementally

These videos show 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 time 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 in the market at the given market price or sold as scrap for a lower amount than its remaining book value.

Read this section about making capital budgeting decisions. When managers and executives make financial decisions to invest limited resources, they use these techniques to invest wisely.

Read this section on depreciation and depreciation methods. Why are depreciation methods used in financial decision making? Real estate and long-term equipment are depreciated when making financial calculations using generally-accepted accounting principles. This helps us make more accurate decisions.

### 3.6: How Capital Budgeting is Used to Make Decisions

You already read this chapter. Now, complete the problem sets about how capital budgeting is used to make decisions.

### Unit 3 Assessment

Take this assessment to see how well you understood this unit.

- This assessment
**does not count towards your grade**. It is just for practice! - You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.

- This assessment