336 Part 4 Investing in Long-Term Assets: Capital Budgeting
In the last chapter, we discussed the cost of capital. Now we turn to investment deci-
sions involving! xed assets, or capital budgeting. Here capital refers to long-term
assets used in production, while a budget is a plan that outlines projected expendi-
tures during some future period. Thus, the capital budget is a summary of planned
investments in long-term assets, and capital budgeting is the whole process of ana-
lyzing projects and deciding which ones to include in the capital budget. Boeing,
Airbus, and other companies use the techniques in this chapter when deciding to
accept or reject proposed capital expenditures.
When you! nish this chapter, you should be able to:• (^) Discuss capital budgeting.
• (^) Calculate and use the major capital budgeting decision criteria, which are NPV,
IRR, MIRR, and payback.
• (^) Explain why NPV is the best criterion and how it overcomes problems inherent in
the other methods.
With an understanding of the theory of capital budgeting developed in this chapter,
which uses simpli! ed examples, you will be ready for the next chapter, where we dis-
cuss how cash " ows are estimated, how risk is measured, and how capital budgeting
decisions are made.
11-1 AN OVERVIEW OF CAPITAL BUDGETING
The same concepts used in security valuation are also used in capital budgeting,
but there are two major differences. First, stocks and bonds exist in the security
markets, and investors select from the available set;! rms, however, create capital
budgeting projects. Second, for most securities, investors have no in" uence on the
cash " ows produced by their investments, whereas corporations have a major
in" uence on projects’ results. Still, in both security valuation and capital budget-
ing, we forecast a set of cash " ows,! nd the present value of those " ows, and make
the investment only if the PV of the in" ows exceeds the investment’s cost.
A! rm’s growth, and even its ability to remain competitive and to survive, de-
pends on a constant " ow of ideas relating to new products, to improvements in
existing products, and to ways of operating more ef! ciently. Accordingly, well-
managed! rms go to great lengths to develop good capital budgeting proposals.
For example, the executive vice president of one successful corporation said that
his company takes the following steps to generate projects:
Our R&D department constantly searches for new products and ways to improve
existing products. In addition, our Executive Committee, which consists of senior
Capital Budgeting
The process of planning
expenditures on assets
with cash flows that are
expected to extend
beyond one year.
Capital Budgeting
The process of planning
expenditures on assets
with cash flows that are
expected to extend
beyond one year.
to purchasing computers and software to optimize
inventory management. The techniques described in this
chapter are required to analyze projects of all types and
sizes.
Sources: John Newhouse, Boeing Versus Airbus: The Inside Story of the Greatest International Competition in Business (New York: Random
House, 2007).
P U T T I N G T H I N G S I N P E R S P E C T I V E