University of Phoenix Material

Capital Budgeting – Clarification Example

When people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. Actually, capital is the more important aspect because it shows you that you are evaluating a larger expenditure that will be capitalized—in other words, depreciated over time. Remember, a capital expenditure can be many things—a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting—the acquisition of another entity. What is important about capital budgeting is it allows you to analyze one or more projects so you can intelligently and strategically decide on which project you wish to acquire or which piece of equipment you should procure.

There are at least six capital budgeting tools you can use in analyzing a capital expenditure: net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period (PB), discounted payback period (DPB), and modified internal rate of return (MIRR), although the textbook mainly focuses on net NPV and IRR. In a prior finance course, you might have learned how to calculate four of the six tools—NPV, IRR, PI, and PB. If not, then this will be new material for you.

Crunching the numbers might seem by some to be the more crucial part—and it is indeed important. However, interpreting and analyzing the answers are just as important. See if you can do this with the six capital budgeting tool answers that you will be computing in the following example.

Example

Suppose you are thinking of acquiring either the ABC or the XYZ Company. Both have a purchase price of $500K so you cannot readily see which choice would be in your best interest. You also have a capital restraint of approximately $500K so you cannot purchase both entities. Thus, you