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Applying Capital Budgeting and Risk Evaluation

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In choosing a particular project, there is a lot of financial planning that must take place. In the Marine Corps, we also use a planning process in developing plans for appropriate action. This process consists of six parts: problem framing, the course of action development, the course of action war-gaming, the course of action comparison / decision, orders development and transitioning.

- During the problem framing stage, it is determined exactly what the problem is by gathering all required intelligence on the issue at hand and why it occurred.
- Next, it is on to course of action (COA) development, where a "think tank" comes up with an array of plans to solve the problem.
- After that, the team "war games" or experiments with the COA's, to determine the pros and cons of each.
- When complete, all findings are brought to the table and feasible solutions are discussed, thus resulting in COA revision/decision.
- Orders for the ways ahead are then established for the accomplishment of the objective and issued to the right personnel for the job.
- Lastly, during the transition phase members of the unit assigned the task to begin to prepare for the mission.
We can equate this process to a project manager's decision-making practice, in that there is a lot of information that is gathered and framed, planned, experimented with, compared, revised/decided upon, drafted and executed.

MCWP 5-1, Marine Corps Planning Process retrieved from:

Ross, S. Westerfield, R. and Jordan, B. (2013) Fundamentals of Corporate Finance standard edition 10th edition. McGraw-Hill/Irwin

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The managers of United Med tronics are evaluating the following four projects for the coming budget period. The firm's corporate cost of capital is 14 percent.
Project Cost IRR
A $20,000 17%
B $15,000 16%
C $12,000 15%
D $18,000 13%
a. What is the firm's optimal capital budget?
b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm's optimal capital budget when differential risk is considered? (Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)
c. Return to the original assumption that all projects have average risk. If United Medtronics are only approved for $30,000 towards their project budget, which project or projects would you accept? (Hint: Any money not used for a project will not receive any return).

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