A Course in Capital Budgeting
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
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
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
Reports on Logistic Engineering (in Dutch)
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