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CFO Fundamentals: Your Quick Guide to Internal Controls, Financial Reporting, IFRS, Web 2.0, Cloud Computing, and More by ALLISON I. SHIM, JOEL G. SIEGEL, JAE K. SHIM

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CHAPTER FOURTEEN

Capital Budgeting and Real Options

WHAT IS CAPITAL BUDGETING?

Capital budgeting is the process of making long-term planning decisions for alternative investment opportunities. The company may have to make many investment decisions in order to grow. Examples of capital budgeting applications are selecting product line, keeping or selling a business segment, leasing or buying, and deciding which asset to invest in.

WHAT ARE THE TYPES OF INVESTMENT PROJECTS?

There are typically two types of long-term investment decisions:

1. Selection decisions involve obtaining new facilities or expanding existing ones. Examples include:

  • Investments in property, plant, and equipment as well as other types of assets
  • Resource commitments in the form of new product development, market research, introduction of a computer, refunding of long-term debt, and so on
  • Mergers and acquisitions in the form of buying another company to add a new product line

2. Replacement decisions involve replacing existing facilities with new ones. Examples include replacing an old machine with a high-tech machine.

WHAT ARE THE FEATURES OF INVESTMENT PROJECTS?

Long-term investments have three important features:

1. They typically involve a large amount of initial cash outlays, which tend to have a long-term impact on the firm’s future profitability. Therefore, this initial cash outlay needs to be justified on a cost-benefit basis.

2. There are expected recurring cash inflows (e.g., increased revenues, ...

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