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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