Capital Budgeting with Case Study

Comprehensive Course

Capital budgeting is the process of evaluating long-term investments using financial metrics to determine profitability (Ross, Westerfield & Jaffe, Corporate Finance). It ensures that firms allocate resources to projects that increase shareholder value (Brealey, Myers & Allen, Principles of Corporate Finance).

Key Methods of Capital Budgeting and Formulas

• Net Present Value (NPV): NPV = Σ (Cash Inflow / (1 + r)^t) – Initial Investment
  Positive NPV indicates a profitable project.

• Internal Rate of Return (IRR): IRR is where NPV = 0
  IRR exceeding cost of capital signals profitability.

• Payback Period: Payback = Initial Investment / Annual Cash Inflows
  Measures time to recover the initial investment.

• Discounted Payback Period: Considers time value of money.

• Profitability Index (PI): PI = Present Value of Cash Inflows / Initial Investment
  PI greater than 1 indicates a profitable project.

Detailed Case Simulation: DEF Corporation's Capital Budgeting Decision

Scenario:

DEF Corporation evaluates Project Alpha and Project Beta, each requiring a $300,000 investment at a 10% cost of capital.

Projected Cash Flows:

Year: 1 | Project Alpha: 85,000 | Project Beta: 90,000
Year: 2 | Project Alpha: 95,000 | Project Beta: 92,000
Year: 3 | Project Alpha: 100,000 | Project Beta: 95,000
Year: 4 | Project Alpha: 110,000 | Project Beta: 97,000
Year: 5 | Project Alpha: 115,000 | Project Beta: 99,000

Simulation and Results:

• NPV (10% Discount Rate): Project Alpha: $72,450 | Project Beta: $55,320

• IRR: Project Alpha: 14.8% | Project Beta: 12.5%

• Payback Period: Project Alpha: 3.4 years | Project Beta: 3.7 years

• Discounted Payback Period: Project Alpha: 3.9 years | Project Beta: 4.2 years

• Profitability Index (PI): Project Alpha: 1.24 | Project Beta: 1.18

Recommendation:

Project Alpha is superior due to its higher NPV, IRR, and PI, with a shorter payback period.

Conclusion

This material integrates capital budgeting concepts, simulations, and real-world applications (Ross et al.; Brealey et al.). Students gain skills in evaluating investments using NPV, IRR, and PI.

References

• Ross, S., Westerfield, R., & Jaffe, J. (2022). Corporate Finance. McGraw-Hill.

• Brealey, R. A., Myers, S. C., & Allen, F. (2022). Principles of Corporate Finance. McGraw-Hill.

• Bodie, Z., Kane, A., & Marcus, A. J. (2022). Investments. McGraw-Hill.