Chapter 1Introduction to Capital Budgeting

Capital Budgeting & Investment Analysis By Alan Shapiro

Introduction to Capital Budgeting

• The most important topic in corporate finance is the analysis of capital expenditures

• Decisions to invest capital determines the firms future course and hence its market value

• Capital Budgeting decision is the allocation of funds among alternative investment opportunities

The capital Budgeting decision

• Capital expenditure is any cash outlay expected to generate cash flows lasting longer than one year.

• Advertising: Brand names

The objective of capital budgeting

• The aim is to maximize the wealth of its shareholders

• People prefer more wealth• Defer consumption and invest• Risk aversion: Bond vs. stock

The importance of Shareholder Value

• Shareholders are the legal owners of the firm and management has a fiduciary obligation to act in the shareholders’ best interests.

• Value gap: The difference between the actual value of the company and the value if it were optimally managed.

• Board of directors becoming more active.

The importance of Shareholder Value cont.

• Maximizing shareholder value is the only way to maximize the economic interests of all stakeholders over time

• Attract equity capital seeking to grow• Maximizing shareholder wealth is tantamount

to maximizing the firm’s share price

Basic Drivers of share value

• Shareholder value depends on cash flow, time, and risk

• The more cash that shareholders receive and the sooner they expect to receive that cash, the better of they are.

• Accounting profits not associated with cash flows are of no value to investors

Basic Drivers of share value cont.

• Enhancing the company’s cash flow generating ability

• Investors discount cash to be received in the future, reducing the value today

• People prefer present consumption over consumption in the future

Basic Drivers of share value cont.

• TVM: a dollar today is worth more than a dollar in the future

• PV and FV• The interest rate at which future cash flows

are discounted increases with risk• Investors are generally risk averse; all things

being equal, they prefer less risk to more risk• Future cash flows are discounted for both

TVM and degree of risk involved.

Capital Budgeting Principles and criteria

• Take all projects that would increase shareholder wealth

• Reject all projects that would decrease shareholder wealth

• Place higher weight on earlier cash flows• Penalize more heavily the expected cash flows

of riskier projects

The capital budgeting process

• Sometimes a project arises naturally, as when a machine tool wears out and must be replaced

• R&D• Decide whether products involved are

commercially viable• Size of market• Consultation with people in engineering,

production, marketing and transportation

The capital budgeting process cont.

• Begin with forecasts of future sales• Convert into production forecasts• Cost of obtaining capital• Capital budgets cannot remain static and

should respond to changes• Oil prices and drilling• Labor costs

Classifying capital budgeting projects

• Investment categories– Equipment replacement– Expansion to meet growth in existing products– Expansion generated by new products– Projects mandated by law

* Risk

Project interaction

• Independent projects– Acceptance or rejection are independent of one

another. They bear no relation to one another– The firm could accept one, both or none.

• Mutually exclusive projects– The acceptance of one precludes the selection of any

alternative projects• Contingent projects– One whose acceptance depends on the adoption of

another project

Summary and conclusions

• The ultimate aim of capital budgeting is to maximize the market value of the company’s common stock in the long run and thereby wealth of shareholders

• Future CFs must be discounted to account for time and risk

• The larger the dollar amount involved, the more scrutiny of the investment there will be