Introduction to Capital Budgeting

The

allocation of funds among alternative investment opportunities. to corporate success.

Crucial

Capital expenditure (Capex): any cash outlay expected to generate cash flows lasting longer than one year. The objective of capital budgeting: is to maximize the market value of the companys common stock and, thereby, the wealth of its shareholders.

Simple economic notion that people try to maximize their well being.

Shareholders are the legal owners of the firm and management has a fiduciary obligation to act in the shareholders best interests. Companies that do not take this approach are likely to wind up with a value gap, which is the difference between the value of the company if it were ultimately managed and the actual value of the company. Maximizing shareholder value is the only way to maximize the economic interests of all stakeholders over time.

The more cash that shareholders receive and the sooner they expect to receive the cash, the better off they are. Alternatively, the riskier the expected future cash flows, the less value shareholders place on them.

Accounting profits not associated with cash flows are of no value to investors.
This means, for example, switching the depreciation methods for reporting, so as to boost reported profits does not benefit shareholders because it does not affect cash flow.

2 other dimensions to shareholder value are:

Time Positive time reference means that people value the current use of resources (goods) more highly than they do their future use. Time Value of Money: the notion that a dollar today is worth more than a dollar in the future. Present Value: value in terms of todays dollars. Future Value: value in terms of future dollars. Risk The interest rate at which future cash flows are discounted increases with risk. Investors demand to be compensated for the risks they expect to bear. This requires discounting the future cash flows for both time value of money and the degree of risk involved.

Select the same projects investors would select if they had the same information. Take all projects that would increase shareholder wealth. Reject all projects that would decrease shareholder wealth.

It should place higher weight on earlier cash flows than on more distant cash flows. It should not weight cash flows arising in different time periods the same. It should value all cash inflows and outflows associated with the project. It should ignore those elements of reported earnings that do not reflect cash flows and factor in any cash inflows and outflows that do not show up in reported earnings. It should penalize more heavily the expected cash flows of riskier projects. Other things being equal, it should rank riskier projects as being less desirable.

Most capital budgets are driven by sales forecasts. Many firms have a policy of decentralizing decisions when possible, and capital budgeting is no exception. Many division managers can initiate their own projects when the proposed investment is below a minimum sum, for example $50K or less.

Investment Categories:
Equipment replacement
Expansion to meet growth in existing products

Expansion generated by new products

Projects mandated by law

Independent projects: totally separate projects. Mutually exclusive projects: the acceptance of one project will preclude the selection of any alternative projects. Contingent projects: One project depends on the acceptance of another project.

Ultimate aim of capital budgeting is to maximize the market value of the companys common stock, and thereby, the wealth of the stockholder. This goal translates into evaluating projects on the basis of their cash flows. To account for the effects of time and risk, future project cash flows must be discounted, with more riskier cash flows being discounted more heavily than nearer and more secure cash flows.