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Chapter 1

Introduction to Capital BudgetingCapital Budgeting & Investment

Analysis By Alan Shapiro

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Introduction to Capital Budgeting

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

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

• Capital Budgeting decision is the allocation offunds among alternative investmentopportunities

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The capital Budgeting decision

• Capital expenditure is any cash outlayexpected to generate cash flows lasting longerthan one year.

• Advertising: Brand names

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The objective of capital budgeting

• The aim is to maximize the wealth of itsshareholders

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

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The importance of Shareholder Value

• Shareholders are the legal owners of the firmand management has a fiduciary obligation toact in the shareholders’ best interests.

• Value gap: The difference between the actualvalue of the company and the value if it wereoptimally managed.

• Board of directors becoming more active.

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The importance of Shareholder Valuecont.

• Maximizing shareholder value is the only wayto maximize the economic interests of allstakeholders over time

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

to maximizing the firm’s share price

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Basic Drivers of share value

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

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

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

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Basic Drivers of share value cont.

• Enhancing the company’s cash flow generatingability

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

• People prefer present consumption overconsumption in the future

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Basic Drivers of share value cont.

• TVM: a dollar today is worth more than adollar 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.

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Capital Budgeting Principles andcriteria

• Take all projects that would increaseshareholder wealth

• Reject all projects that would decreaseshareholder wealth

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

of riskier projects

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The capital budgeting process

• Sometimes a project arises naturally, as whena machine tool wears out and must bereplaced

• R&D• Decide whether products involved are

commercially viable•

Size of market• Consultation with people in engineering,

production, marketing and transportation

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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

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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

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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 anyalternative projects

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

another project

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Summary and conclusions

• The ultimate aim of capital budgeting is tomaximize the market value of the company’scommon stock in the long run and therebywealth of shareholders

• Future CFs must be discounted to account fortime and risk

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