Capital Budgeting

Module 5 summary

Capital budgeting evaluation criteria and cost of capital

In this module, you study capital budgeting decision criteria. The module begins by explaining the discount rate to apply to an investment project. Capital budgeting and risk are explored. You look at using the CAPM model to create a risk-adjusted discount rate (RADR) for capital budgeting. You also explore RADRs by project. The relationship between NPV and other frequently-employed capital budgeting criteria is explained. You calculate the internal rate of return of an investment. You also learn how to select projects when there is a constraint on the amount of capital the firm can spend on new projects (capital rationing).

In the second part of the module, you study how a company determines its cost of capital. This includes calculating the component weights and component costs for debt, preferred shares, and common shares. The weighted average cost of capital (WACC) is explained. Finally, you learn how to allocate projects to risk classes.

Explain why net present value (NPV) is the preferred capital budgeting criterion, and illustrate how it is implemented.

* NPV meets two critical requirements for capital budgeting:

* It accounts for the time value of money.

* It considers all relevant cash flows. 

* NPV measures the increase in value to the firm.

* The NPV rule accepts all investment projects that have a positive net present value, subject to capital rationing constraints.

* The NPV calculation incorporates all relevant cash flows, including:

* cash outlays to acquire capital assets, discounted to the present

* present value of tax shield (PVTS) on capital outlays

* salvage values, discounted to the present

* capital gains tax on land disposed of, if applicable, discounted to the present

* the PVTS lost on other assets disposed of at the end of the project

* after-tax net cash inflows (that is, increased...