This type of analysis can be used to determine a project’s economic life,which is
the life that maximizes the NPV and thus maximizes shareholder wealth. For Project
A, the economic life is two years versus the three-year physical,or engineering, life.
Note that this analysis was based on the expected cash flows and the expected salvage
values, and it should always be conducted as a part of the capital budgeting evaluation
if salvage values are relatively high.
Briefly describe the replacement chain (common life) approach.
Define the economic life of a project (as opposed to its physical life).
The Optimal Capital Budget
The optimal capital budgetis the set of projects that maximizes the value of the firm.
Finance theory states that all projects with positive NPVs should be accepted, and the
optimal capital budget consists of these positive NPV projects. However, two compli-
cations arise in practice: (1) an increasing marginal cost of capital and (2) capital
rationing.
An Increasing Marginal Cost of Capital
The cost o fcapital may depend on the size o fthe capital budget. As we discussed in
Chapter 6, the flotation costs associated with issuing new equity or public debt can
be quite high. This means that the cost o fcapital jumps upward a fter a company in-
vests all o fits internally generated cash and must sell new common stock. In addi-
tion, investors often perceive extremely large capital investments to be riskier, which
may also drive up the cost o fcapital as the size o fthe capital budget increases. As a
result, a project might have a positive NPV i fit is part o fa “normal size” capital bud-
get, but the same project might have a negative NPV i fit is part o fan unusually large
capital budget. Fortunately, this problem occurs very rarely for most firms, and it is
unusual for an established firm to require new outside equity. Still, the Web Exten-
sion for this chapter on the textbook’s web site contains a more detailed discussion of
this problem and shows how to deal with the existence o fan increasing marginal cost
o fcapital.
Capital Rationing
Armbrister Pyrotechnics, a manufacturer of fireworks and lasers for light shows, has
identified 40 potential independent projects, with 15 having a positive NPV based on
the firm’s 12 percent cost of capital. The total cost of implementing these 15 projects
is $75 million. Based on finance theory, the optimal capital budget is $75 million, and
Armbrister should accept the 15 projects with positive NPVs. However, Armbrister’s
management has imposed a limit of $50 million for capital expenditures during the
upcoming year. Due to this restriction, the company must forego a number of value-
adding projects. This is an example of capital rationing,defined as a situation in
which a firm limits its capital expenditures to less than the amount required to fund
the optimal capital budget. Despite being at odds with finance theory, this practice is
quite common.
284 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows
282 The Basics of Capital Budgeting: Evaluating Cash Flows
