Week 8 Overview

Week 8: Overview

Capital Budgeting

Welcome to the eighth week of BUSN 5200: Basic Finance for Managers. This week we take up the subject of capital budgeting, which, as the name implies, involves budgeting the firm’s capital. Capital budgeting, in other words, is concerned with deciding what to do with the firm’s money. It is sometimes referred to as The Investment Decision.

The Relevance of Capital Budgeting for Non-Financial Managers
Remember at the beginning of the course we established that the objective of all managers in a business is to work towards maximizing the wealth of the firm’s owners (stockholders in the case of corporations). The wealth of the firm’s owners is measured by the value of their ownership interest in the firm, so another way to express the objective of a firm’s managers is to say it is to maximize the value of the firm. The claimants (right-hand side of the balance sheet consisting of debt-holders and owners) require a return on the money they have provided to the firm, which is considered under the concept of Cost of Capital.  For managers to maximize the wealth of the firm's owners, they must choose projects that return higher than the cost of capital.  Estimating cost of capital is beyond the scope of this course.  Regardless, Capital Budgeting ties in with this objective by providing a way to decide which investments should be undertaken or rejected such that the value of the firm is maximized.

Applicability of Capital Budgeting Techniques
Capital Budgeting normally applies to large, long-term projects. Should a new factory be built? Should another firm be acquired? Should a new product be developed? And so on. As you can imagine, capital budgeting decisions can get pretty involved. For this reason, formal capital budgeting analyses are normally reserved for “big-deal” projects. Small short-term projects are not usually evaluated using capital budgeting techniques.

Objectives

By the end of this week, students will be expected to:

  • Calculate payback periods
  • Calculate a breakeven point and read a breakeven chart
  • Apply the NPV and IRR criteria to evaluate the merits of a project