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Corporate Financial Management 3e
Emery Finnerty Stowe
Capital Budgeting In Practice
Learning Objectives
Describe the important role of capital budgeting options in valuing projects.
Distinguish between hard and soft capital rationing.
Describe the important role in capital budgeting of factors that are difficult to quantify.
Explain the drawbacks of simple mechanical rules plex capital budgeting cases.
Apply the principles of finance to capital budgeting.
Chapter Outline
The Price-Setting Option
Real Options
Capital Rationing
Managing the Firm’s Capital Budget
Other Factors that are Difficult to Quantify
Some Practical Advice
Focus on Principles
Options
Recognize the options embedded in a capital budgeting project.
Two-Sided Transactions
Consider why the party on the other side of the transaction is willing to participate.
Signaling
Consider the actions and products petitors.
Focus on Principles
Valuable Ideas
Look for new ideas to use as a basis for capital budgeting projects that will create value.
Comparative Advantage
Look for projects that exploit the firm’parative advantage.
Incremental Benefits
Identify and estimate the incremental expected after-tax future cash flows for a project.
Focus on Principles
Signaling
Consider the actions and products petitors.
Time-Value-Of-Money
Measure the value of the project: its NPV.
The Price-Setting Option
The two alternatives faced by the SureGrip Leather Co. (SLC) are:
1. Expand capacity, NPV = $850,000.
2. Increase unit wholesale price.
SLC should choose the alternative that has the highest positive NPV.
The Price-Setting Option
Suppose we know the demand curve, shown below. Then, the maximum unit price, given production capacity, can be calculated by setting the quantity demanded equal to capacity and solving for the price:
The Price-Setting Option
This new price of $ is $ higher than the current wholesale price.
By selling 8 million units per year, SL