CHAPTER 2

CAPITAL BUDGETING

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

- Describe the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projects.
- Describe the basic principles of capital budgeting, including cash flow estimation.
- Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing.
- Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, average accounting rate of return (AAR), and profitability index (PI).
- Explain the NPV profile, compare NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods.
- Describe the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price.
- Describe the expected relations among an investment’s NPV, company value, and stock price.
- Calculate the yearly cash flows of an expansion capital project and a replacement capital project, and evaluate how the choice of depreciation method affects those cash flows.
- Explain the effects of inflation on capital budgeting analysis.
- Evaluate and select the optimal capital project in situations ...