Note that the term “assets” encompasses more than buildings and equipment.
Computer software that a firm develops to help it buy supplies and materials more ef-
ficiently, or to communicate with customers, is also an asset, as is a customer base like
the one AOL developed by sending out millions of free CDs to potential customers.
All of these are “intangible” as opposed to “tangible” assets, but decisions to invest in
them are analyzed in the same way as decisions related to tangible assets. Keep this in
mind as you go through the remainder of the chapter.
Identify the major project classification categories, and explain how they are
used.
Capital Budgeting Decision Rules
Six key methods are used to rank projects and to decide whether or not they should be
accepted for inclusion in the capital budget: (1) payback, (2) discounted payback,
(3) net present value (NPV), (4) internal rate of return (IRR), (5) modified internal
rate of return (MIRR), and (6) profitability index (PI). We will explain how each rank-
ing criterion is calculated, and then we will evaluate how well each performs in terms
of identifying those projects that will maximize the firm’s stock price.
The first, and most difficult, step in project analysis is estimating the relevant cash
flows, a step that Chapter 8 explains in detail. Our present focus is on the different de-
cision rules, so we provide the cash flows used in this chapter, starting with the ex-
pected cash flows of Project S and L in Figure 7–1. These projects are equally risky,
and the cash flows for each year, CFt, reflect purchase cost, investments in working
capital, taxes, depreciation, and salvage values. Finally, we assume that all cash flows
occur at the end of the designated year. Incidentally, the S stands for shortand the L
for long:Project S is a short-term project in the sense that its cash inflows come in
sooner than L’s.
262 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows
FIGURE 7-1 Net Cash Flows for Projects S and L
Expected After-Tax
Net Cash Flows, CFt
Year (t) Project S Project L
0 a ($1,000) ($1,000)
1 500 100
2 400 300
3 300 400
4 100 600
01234
Project S:
1,000 500 400 300 100
01234
Project L:
1,000 100 300 400 600
aCF 0 represents the cash flow experienced at the project’s inception.
260 The Basics of Capital Budgeting: Evaluating Cash Flows
