### 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

Read this section that discusses the following net present value concepts: (1) Net Present Values (NPV): (2) Calculating NPV; (3) Interpreting NPV; (4) Advantages of Using NPV; (5) Disadvantages of Using NPV; and (6) NPV Profiles. Examples of these concepts are shared about how to implement these concepts in practical applications.

### 3.2: Internal Rate of Return

Read this section about Internal Rate of Return (IRR). Particular attention should be given to the following topics: (1) Internal Rate of Return; (2) Definition of Internal Rate of Return; (3)Calculating Internal Rate of Return ; (4) Advantages of Using Internal Rate of Return: (5) Disadvantages of Using Internal Rate of Return ; (6) Calculating Multiple Internal Rates of Return and ; (7) Understanding and calculating Modified Internal Rates of Return. Problems and solutions are also provided in this section.

### 3.3: Profitability Index

Read this section that discusses capital budgeting and ranking investment proposals. The importance of this subject arises when businesses are comparing similar real estates investments with the intent of picking the investment that yields the highest return. Several methods are presented in this section and 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). The formulas and examples are given to demonstrate how to apply these formulas in the real world.

Read this section that discusses methods of evaluating capital budgeting, calculating the profitability index and discuss the modified internal rate of return (MIRR). Two separate investment proposals are compared and contrasted using multiple methods of comparison. This method of comparison gives the student or manager a broad view about 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 that presents the Payback Method of investing. Specific emphasis is given to (1) Defining the payback method, (2) Calculating the payback method, (3) Discounted payback, (4) Advantages of the payback method, and (5) Disadvantages of the payback method. Examples that demonstrate application are presented in this section.

### 3.5: 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 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. The discussion includes the following: (1) Goals of Capital Budgeting, (2) Ranking of Investment Proposals, (3) Reinvestment Assumptions, (4) Long term and short term financing , (5) Payback Method (PM), (6) Internal Rate of Return(IRR), (7) Net Present Value (NPV), and (8) Cash Flow Analysis. Who uses these capital budgeting decisions? The answers to these questions are contained in this section. When managers and executives make financial decisions to invest limited resources, they use the information presented in this section because they are more likely to invest wisely.

Read this section that presents the concept of depreciation and depreciation methods. Why are depreciation methods used in financial decision making? Real estate and long-term equipment is depreciated when making financial calculations using generally accepted accounting principles so that more accurate decisions are made. Examples are used to illustrate how long term assets are depreciated to arrive at more accurate financial calculations and the decisions that are result.

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

You have already read this chapter. Please now complete the problem sets pertaining to how capital budgeting is used to make decisions. Do corporations actually use capital budgeting concepts and formulas to make decisions? Concepts and examples are presented using Net Present Value (NPV), Present Value (PV) tables, summaries and problems are presented. Internal Rate of Return (IRR), Net Present Value (NPV) and the payback method are presented along with examples that demonstrate application. Examples are presented and discussed with respect to Kohls and J.C. Penny's using capital budgeting 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