378 PART 3 Long-Term Investment Decisions
Techniques for analyzing conventional cash flow patterns to determine
whether to undertake a proposed capital investment are discussed in Chapter 9.Review Question
8–16 Diagram and describe the three components of the relevant cash flowsfor
a capital budgeting project.SUMMARY
FOCUS ON VALUE
A key responsibility of financial managers is to review and analyze proposed investment
decisions in order to make sure that only those that contribute positively to the value of the
firm are undertaken. Utilizing a variety of tools and techniques, financial managers estimate
the cash flows that a proposed investment will generate and then apply appropriate decision
techniques to assess the investment’s impact on the firm’s value. The most difficult and
important aspect of this capital budgeting process is developing good estimates of the rele-
vant cash flows.
The relevant cash flows are the incremental after-tax cash flows resulting from a pro-
posed investment. These estimates represent the cash flow benefits that are likely to accrue
to the firm as a result of implementing the investment. By applying to the cash flows deci-
sion techniques that capture time value of money and risk factors, the financial manager
can estimate the impact the investment will have on the firm’s share price. Clearly, only
those investments that can be expected to increase the stock price should be undertaken.
Consistent application of capital budgeting procedures to proposed long-term investments
should therefore allow the firm to maximize its stock price.
REVIEW OF LEARNING GOALS
Understand the key motives for capital expen-
diture and the steps in the capital budgeting
process. Capital budgeting is the process used to
evaluate and select capital expenditures consistent
with the firm’s goal of maximizing owner wealth.
Capital expenditures are long-term investments
made to expand, replace, or renew fixed assets or to
obtain some less tangible benefit. The capital bud-
geting process includes five distinct but interrelated
LG1 steps: proposal generation, review and analysis,
decision making, implementation, and follow-up.Define basic capital budgeting terminology.
Capital expenditure proposals may be indepen-
dent or mutually exclusive. Typically, firms have
only limited funds for capital investments and must
ration them among carefully selected projects. Two
basic approaches to capital budgeting decisions areLG2