This is “Introduction to Capital Budgeting Techniques”, section 13.1 from the book Finance for Managers (v. 0.1).
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The goal with capital budgeting is to select the projects that bring the most value to the firm. Ideally, we’d like to select all of the projects that add value, and avoid those that lose value. In an ideal situation, we can raise sufficient financing to undertake all of these value adding projects. By default, we will assume most firms are operating in this environment.
Some firms, however, have the additional limitation of using capital rationingWhen a firm has limited funds to dedicate to capital projects, and projects compete for these limited funds., in that they have a determined amount of funds available to allocate to capital projects, and the projects will compete for these funds. This can occur if the firm has difficulty accessing capital markets, for example. Under capital rationing, some projects that add value might not have sufficient funds to proceed, so the goal is to select the subset of profitable projects that maximizes value. There exist linear programming techniques that can be used when faced with a capital rationing constraint; they are, however, beyond the scope of this text.
We’ll look at three popular decision making techniques: Payback Period, Net Present Value (NPV), and internal rate of return (IRR). There exist a multitude of lesser used techniques, many of which are variants of these three most popular, but these three are the most commonly used today.
When we shop for our first car, we might find many available options that meet our minimum criteria of price, model, color, etc. Will we purchase all of those that meet the cutoff? Of course not! We only need one car, so we will pick only the best one. We have no need of a second car, at this point in our lives, so the purchase of one car excludes the purchase of a second.
If only one project can be selected from a set of projects (usually by making the other options unnecessary), they are mutually exclusive projectsA decision where only one project can be selected from a set of projects (usually by making the other options unnecessary).. For example, consider if our company needs more capacity to make product, and we decide to build one new plant. If we build the plant in Mexico, then we won’t also want to build one in Canada, since we only need one. Projects that compete with each other or eliminate the need for the other projects are mutually exclusive. In this case, we will only select the option that is best by our decision criteria.
If, instead, we consider projects that are operationally unrelated to each other, we can choose to do none of them, all of them, or some subset of the projects. These projects are independent projectsA decision where the cash flows of one project are not influenced by the selection of other projects., where the cash flows of one project are not influenced by the selection of other projects. If the project meets the minimum capital budgeting requirements then we should undertake the project.
Capital budgeting techniques help us determine which project to undertake. First we need to determine the relevant cash flows and whether or not the projects are independent or mutually exclusive.
Are these mutually exclusive or independent projects?