Chapter 8
Capital Budgeting
Go to the Chapter 8 folder in the Additional Instructor Resources & Solutions folder to
find the Excel spread sheets and other resources that accompany this chapter’s material.
Chapter Overview
I. Introduction
II. Defining capital budgeting
a. What is capital?
b. Capital expenditure
c. Weighted average cost of capital (WACC)
d. Current expenditure
III. The process of capital budgeting
a. Determine the initial cost of the project
b. Determine the incremental cash flow of a project
c. Select the capital budgeting method
iii. Net present value
1. Two-project NPV calculation
2. Single-project NPV calculation
3. Advantages and disadvantages of NPV
IV. Conclusion
Key Concepts
When reading this chapter, students should focus on the following key concepts:
1. Capital budgeting is used to analyze an organization’s capital expenditures.
2. Five capital budgeting methods can be used to analyze capital projects; each one
provides relevant information useful to management when selecting a project
for inclusion in the organization’s capital budget.
Quiz Questions
1. Which of the following is the number of years required to recover the initial
capital investment of an organization?
a. Payback period
b. Discounted payback period
2. Which of the following is a discounted cash flow method that compares the
present value of a project’s future cash flows to its initial costs?
a. Payback period
b. Discounted payback period
c. Net present value
3. As facility projects can often lead to non-normal cash flows, it is recommended
that which of the following be used when developing a capital budget?
a. Payback period
b. Discounted payback period
4. Which of the following is the discount rate that makes the present value of the
estimated cash flows equal to the initial cost of the investment?
d. Internal rate of return
e. Modified internal rate of return
5. Using this method of capital budgeting, expected cash flows are discounted by
the project’s initial cost of capital to determine when the project will break even.
a. Payback period
b. Discounted payback period
6. Of the following capital budgeting methods, which one ignores the time value of
money as it fails to take into account the cost of capital?
d. Internal rate of return
e. Modified internal rate of return
7. Which capital budgeting method is preferred by most managers as it analyzes
cash flows rather than net earnings?
a. Payback period
b. Discounted payback period
8. Which of the following is the final step in the capital budgeting process?
d. Determine the initial cost of the project
e. None of the above
9. The required rate of return to justify an investment in a capital project is the
__________.
a. Interest rate
b. Financing rate
10. The initial cost of a capital project is the actual cost of starting the project
adjusted for which of the following?
d. Taxes
e. All of the above
Answers to Quiz Questions
1. a (p. 197)
2. c (p. 200)
Responses
1. What is capital budgeting?
See pages 192–193. Capital budgeting is the process of evaluating, comparing,
2. What major information (data) do you need for capital budgeting when you
want to compare projects?
See pages 193 through 196. First, you need to calculate the initial cost of the
project. Here you will need the project’s invoice price, adjustments made to
the price, discounts made on the price, information on the sale of equipment
made related to the project, and tax information related to the sale of the
equipment.
3. What relevant information is provided with each capital budgeting method?
See pages 197 through 207.
• Payback Period—indicates the length of time the firm’s funds will be
tied up in a project (the project’s liquidity)
4. What is the problem with multiple IRRs, and when in sport would they occur?
See page 206. Multiple IRRs indicate different rates of profitability for a
project. To make a wise decision, one must ensure that the IRR is greater than
5. In sport, which method of capital budgeting is superior? Why?
See pages 201 and 206 through 207. MIRR is preferred to IRR because non-
normal cash flow is prevalent in the sport industry, especially in sport venues.
6. What is the purpose of the post audit in the capital budgeting process?
See pages 207 through 209. The purpose is to compare the project’s actual
results to the predicted results and attempt to explain any differences. This
Responses
Note: The solutions to Problems 1–5 and 7 are in the Additional Instructor Resources
& Solutions folder for Chapter 8—“Practice Problems Solutions.”
1. Project M has a cost of $65,125, expected net cash inflows are $13,000 per
year for 10 years, and a cost of capital of 11%. What is the project’s payback
period (to the closest year)?
2. Refer to Problem 1. What is the project’s NPV?
7. Your division is considering two facility investment projects, each of which
requires an up-front expenditure of $15 million. You estimate that the
investments will produce the following net cash flows:
Year
Project A
Project B
1
$5,000,000
$20,000,000
2
10,000,000
10,000,000
3
20,000,000
6,000,000
What are the project’s net present values, assuming the cost of capital is 10%? 5%?
15%? What does this analysis tell you about the projects?
Responses to Questions
Note: This problem is essentially a capstone problem for the first eight chapters of
the textbook. Answers will vary widely. Two solution files from a similar version of
this assignment were completed by students in a 400-level class and are included
here. For each solution, there is a Word file and an Excel file, found in the Additional
Instructors Resources & Solutions folder.
1. Based on the facts presented, does this project “make sense”? Be sure to
calculate NPV, IRR or MIRR when answering this question. Assume a 30-year
useful life for the facility.
2. Based on your analysis in Question 1, would you recommend any changes to
the proposed venue? Why or why not?
Changes likely will be recommended based on the pure capital budgeting
analysis. The Word files (Case Analysis Solutions) provide additional funding
Additional Classroom/Exam Problems
Note: The solution to this problem is in the Additional Problems Solution File, found
in the Additional Instructors Resources & Solutions folder.
You are the financial analyst for the University of South Carolina’s athletic
a. In Excel, calculate each project’s payback period and discounted payback
period.