Finance 370 Week 3

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Finance 370 Week 3: Capital Budgeting

Week 3 of Finance 370 typically delves into the core concepts and techniques of **capital budgeting**, a critical area of financial decision-making. This week focuses on how firms evaluate potential investment projects to determine which will create value for shareholders and contribute to long-term growth. The primary goal is to understand the methodologies used to analyze and select profitable investment opportunities. A key concept explored is the **time value of money**. The understanding that money received today is worth more than the same amount received in the future due to its potential earning capacity. This concept forms the bedrock of capital budgeting techniques. Students learn to use **discounting** to bring future cash flows back to their present value. Several methods for evaluating capital investment proposals are covered, each with its strengths and weaknesses. A primary focus is on **Net Present Value (NPV)**. NPV calculates the present value of all expected future cash flows from a project, minus the initial investment. A positive NPV indicates that the project is expected to increase shareholder wealth, making it acceptable. The formula is thoroughly analyzed, and students practice applying it to various scenarios. Another method discussed is the **Internal Rate of Return (IRR)**. IRR is the discount rate that makes the NPV of a project equal to zero. It represents the expected rate of return generated by the project. If the IRR exceeds the company’s cost of capital, the project is generally considered acceptable. Students learn how to calculate IRR and interpret its results, but also learn the potential pitfalls of relying solely on IRR, especially when comparing mutually exclusive projects. **Payback Period** is another method. It measures the time it takes for the project to generate enough cash flow to recover the initial investment. While simple to calculate and understand, it’s often criticized for ignoring the time value of money and cash flows occurring after the payback period. It is typically used as a supplemental tool rather than the primary decision-making criterion. The week also covers the **Profitability Index (PI)**, which is the ratio of the present value of future cash flows to the initial investment. A PI greater than 1 indicates that the project is expected to be profitable. The PI is particularly useful when a company faces capital rationing and needs to select the projects that provide the highest return per dollar invested. Crucially, the course emphasizes the importance of **incremental cash flows** in capital budgeting. The focus should be on the change in the firm’s cash flows as a direct result of accepting the project. Sunk costs (costs already incurred and unrecoverable) are irrelevant to the decision, while opportunity costs (the value of the next best alternative use of resources) must be considered. Finally, week 3 often touches on the concept of **risk analysis** in capital budgeting. This involves understanding the various sources of uncertainty that can affect a project’s cash flows and using techniques such as sensitivity analysis, scenario analysis, and simulation to assess the potential impact of these uncertainties on the project’s profitability. Considering the impact of inflation is also typically addressed. By the end of week 3, students should be able to apply these capital budgeting techniques to real-world scenarios, understand their underlying assumptions, and interpret the results to make informed investment decisions that maximize shareholder value.

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