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Notes: FIN 303 Spring 09, Part 7 – Capital Budgeting Professor James P. Dow, Jr. Part 7. Capital Budgeting What is Capital Budgeting? Nancy Garcia and Digital Solutions Digital Solutions, a software development house, is considering a number of new projects, including a joint venture with another company. Digital Solutions would provide the software expertise to do the development, while the other company, American Financial Consultants (AFC) would be responsible for the marketing. Nancy Garcia of Digital Solutions would be responsible for assessing the financial viability of the plan. Information about the costs and revenues of the project would come from the accounting, production and marketing groups of the two companies; however,…show more content…
She (and we) will approach the problem in five steps: 1. Determine the relevant cash flows including different possible outcomes. 2. Assess the rough financial viability of the most-likely outcome. 3. Use more sophisticated capital budgeting techniques to evaluate the project. 4. Provide quantitative measures of risks the project faces. 5 Determine how these risks affect the decision to do the project. The Time-Line of a Capital Project The first step in any capital budgeting decision is to list all the relevant cash flows. This is the hardest part of the process since it depends on having a detailed understanding of the business and requires the manager to forecast what will happen with the project in the future. It is also the most important part of the process, since if the cash flows are wrong, measures of the profitability of the project will be wrong too. Many capital projects have a similar structure: An initial investment by a firm, followed by a number of periods of regular cash inflow, followed by a terminal payment that ends the project. Our methods of evaluating projects don’t depend on this structure, but it can be helpful to think of a project this way when determining cash flows in order to be sure that you don’t forget any beginning or ending payments or costs. Nancy’s project has this kind of structure. The plan is for Digital Solutions to use its own software engineers and some temporary contract workers to develop

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