This chapter’s focus is oncapital budgeting,the process o fevaluating specific invest-
ment decisions. Here the termcapitalrefers to operating assets used in production,
while abudgetis a plan that details projected cash flows during some future period.
Thus, thecapital budgetis an outline o fplanned investments in operating assets, and
capital budgetingis the whole process o fanalyzing projects and deciding which
ones to include in the capital budget.
Our treatment of capital budgeting is divided into three chapters. This chapter
provides an overview of the capital budgeting process and explains the basic tech-
niques used to evaluate cash flows. Chapter 8 then explains how to estimate a project’s
cash flows and risk. Finally, some projects provide managers with opportunities to re-
act to changing market conditions. These opportunities, called “real options,” are de-
scribed in Chapter 17.
As you read this chapter, think about Coors and how it uses capital budgeting to
create value for shareholders.
Overview of Capital Budgeting
Capital budgeting is perhaps the most important task faced by financial managers and
their staffs. First, a firm’s capital budgeting decisions define its strategic direction, be-
cause moves into new products, services, or markets must be preceded by capital ex-
penditures. Second, the results of capital budgeting decisions continue for many
years, reducing flexibility. Third, poor capital budgeting can have serious financial
consequences. If the firm invests too much, it will incur unnecessarily high deprecia-
tion and other expenses. On the other hand, if it does not invest enough, its equip-
ment and computer software may not be sufficiently modern to enable it to produce
competitively. Also, if it has inadequate capacity, it may lose market share to rival
firms, and regaining lost customers requires heavy selling expenses, price reductions,
or product improvements, all of which are costly.
The same general concepts that are used in security valuation are also involved in
capital budgeting. However, whereas a set of stocks and bonds exists in the securities
market, and investors select from this set, capital budgeting projects are created by the
firm.For example, a sales representative may report that customers are asking for a
particular product that the company does not now produce. The sales manager then
discusses the idea with the marketing research group to determine the size of the
market for the proposed product. If it appears that a significant market does exist, cost
accountants and engineers will be asked to estimate production costs. If they con-
clude that the product can be produced and sold at a sufficient profit, the project will
be undertaken.
A firm’s growth, and even its ability to remain competitive and to survive, depends
on a constant flow of ideas for new products, for ways to make existing products bet-
ter, and for ways to operate at a lower cost. Accordingly, a well-managed firm will go
to great lengths to encourage good capital budgeting proposals from its employees. If
a firm has capable and imaginative executives and employees, and if its incentive sys-
tem is working properly, many ideas for capital investment will be advanced. Some
ideas will be good ones, but others will not. Therefore, companies must screen proj-
ects for those that add value, the primary topic of this chapter.
Why are capital budgeting decisions so important?
What are some ways firms get ideas for capital projects?
260 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows
The textbook’s web site
contains an Excel file that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 07
Tool Kit.xls, and we encour-
age you to open the file and
follow along as you read the
chapter.
258 The Basics of Capital Budgeting: Evaluating Cash Flows
