Case Study

Case Study # 3

Capital Budgeting at RB Investments

John Smith, Phil McDonald, and Michelle Stewart were assigned the task of explaining the elements of financial management to RB’s board of directors. The team in now preparing to deliver a report that deals with the basics of capital budgeting. The capital budgeting reports are timely, because the firm is currently analyzing multiple projects.

The capital budgeting reports will focus on the different criteria the board could use to evaluate proposed capital expenditures. RB’s top managers have discussed the appropriateness of different criteria, including the choice between NPV and IRR, and that will be one focus of the report. The team decided that the report would be most valuable if they used “real life” examples RB is currently evaluating.

RB has a capital budgeting model to analyze all of its proposed projects. The model first forecasts each project’s cash flows, after which it calculates the Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI).

Ray Redd, the president, asked Phil to also issue the reports to the controller and the vice presidents for marketing, production, and human resources. Those executives must provide critical inputs for capital budgeting decision, and Ray wants to make sure they know how the data they provide is used to analyze and make capital budgeting decisions. In addition, several executive have questioned the weight that Phil McDonald has given to the decision criteria in actual capital budgeting decisions. For example, both the controller and the VP for marketing think that the most weight should be given to the payback period, and that any project with a payback of less than 3 years should be accepted. Similarly, the VP for production thinks that the PI is the best method, but several directors seem more comfortable with the IRR. Phil personally would like to consider only the NPV – he would have had Michelle...