Introduction to Corporate Finance

Capital budgeting

9 Capital budgeting process and decision criteria

10 Cash flow and capital budgeting

11 Risk and capital budgeting

The long-run success or failure of most

businesses depends critically on the quality of

their investment decisions. For many companies,

the most important investment decisions are

those that involve the acquisition of fixed assets

such as manufacturing plants and equipment. In

finance, we refer to the process of making these

investment decisions as capital budgeting. This

part of the text focuses exclusively on capital

budgeting.

Chapter 9 describes some of the methods

that companies use to evaluate investment

opportunities. The preferred approach is

the net present value (or NPV) method. In

an NPV analysis, a financial manager derives

the incremental cash flows associated with a

particular investment and discounts those cash

flows at a rate that reflects the investment’s risk.

If the present value of the discounted cash flows

exceeds the cost of the project, the project has

a positive NPV. The investment rule is to invest

when the NPV is positive.

Chapter 10 goes deeper into NPV analysis

by showing how analysts derive the cash flow

estimates necessary to calculate a project’s NPV.

Experienced analysts know that certain types

of cash flows occur in almost any investment

project, so Chapter 9 lists several categories

of cash flows and explains how to treat them

properly in an NPV calculation.

Chapter 11 focuses on the second step in

calculating NPVs: choosing the rate at which

the investment’s cash flows will be discounted.

Conceptually, the discount rate should reflect

the risk of the investment being analysed.

Analysts should use higher discount rates

when they evaluate riskier investment projects.

Furthermore, managers should ‘look to the

market’ to estimate what rate of return investors

expect the company to achieve. The market

rates on debt and equity can be combined

to determine the underlying required return

on a company’s assets, which is the weighted

average cost of capital (or WACC) for their

company. The WACC establishes an important

‘hurdle rate’ for companies. On average, if the

company purchases assets that generate returns

greater than the company’s WACC, then the

company’s investors earn a positive risk-adjust

return, which creates wealth for shareholders.

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