Delft University of Technology
Faculty Mechanical, Maritime and Materials Engineering

Faculty Mechanical, Maritime and Materials Engineering
Transport Technology / Logistic Engineering

A.M. Joekes A Course in Capital Budgeting
Computer program, Report 2002.LT.6687, Transport Technology, Logistic Engineering.

This report is written for Mechanical Engineering students encountering financial issues concerning investments during their graduation project. The main question this report answers is: "How to calculate the value of an investment?".

The economic science dealing with investment valuations is called capital budgeting. The fundamental economic concepts of capital budgeting are explained. The traditional accounting method with its focus on earnings is discussed. Because this method fails to calculate the true value of an investment, the discounted cash flow methods (DCF) are introduced. These methods do calculate the value added by discounting the cash flows (ingoing and outgoing flows of money) generated by the investment at an appropriate discount rate.

The more recently developed value management models (VBM) can also be used to calculate value added. A combination of the DCF methods and the VBM models provides the best solution in capital budgeting. The most optimal combination is the net present value (NPV), and the residual cash flow model (RCF).

There is a gap between theory and practice in capital budgeting. Due to disappointing results with the standard evaluation models, a shift in the trend of appraisal techniques is apparent. Initially, firms were assisted by the traditional accounting methods. Later, the DCF methods improved the method of evaluation and replaced the old techniques. The coming use of value management models is, therefore, a drift in the use of standard capital budgeting methods.

There are two ways to deal with uncertainty in evaluating an investment. The first type of methods, determines the specific risk or specific options of the investment and adjusts the generated cash flows. Two examples of this type are asset valuation and option pricing. The second method provides an overview of all possible outcomes of the investment project, by creating a decision tree or by simulation.

The theory presented in this course is applied in a Capital Budgeting Model, which enables the user to calculate various aspects of investments, such as the NPV, IRR and perform a sensitivity analysis and break even analysis.

Reports on Logistic Engineering (in Dutch)
Modified: 2002.11.13; , TU Delft / 3mE / TT / LT.