Chapter 1

Introduction 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 firms 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 companys 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 companys
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