Chapter 1: Long-term Financial Decisions u Why are capital budgeting decisions important to the firm, society, and to you personally in your career or private life? u Three things that make capital budgeting decisions important: u 1 Capital projects involve large amounts of money. u 2 Capital projects are typically hard (or costly) to reverse. u 3 Capital projects and related financing are the source of all wealth to the firm and its stockholders.

Stakeholders and Competing Desires u Stakeholder: What their goals are (what they want): u Managers High Salary and perquisites. u CreditorsLow risk, return of their money and interest u CustomersLow prices and lots of features u EmployeesHigh salaries, job security u SuppliersHigh prices and long relationships u SocietyGood citizenship and taxes u OwnersDividends or stock appreciation

Economic Profit – A Single Period Measure of Wealth u Economic Profit: Revenues -Expenses Accounting Profit Required Return (Computed as RRR * Investment) Economic Profit (this is wealth created for a single period)

Wealth Creation versus Accounting Profit u A firm should maximize economic profit or wealth instead of profits because: u Wealth includes risk while profit does not. u Wealth is three dimensional u (revenues, cost and risk) u Profit is two dimensional u ( revenues and cost)

Other Definitions of Economic Profit u Economic profit = accounting income – opportunity cost of equity u Economic profit = Equity X (ROE – Ke) where Ke is the required return on equity u Economic profit = Assets X (ROTA - Ka) where Ka is required return on assets

Profitability measures & choice Accounting income Required income (12%) Economic profit $50 $100 $ $26 $40 ROTA ROE 5% 4% 25% 20% Assets Equity $1,000 $2,500 $5, ,000

Net Present Value – A Multi-period Measure of Wealth u Net Present Value: u Take the present value of a series of future economic profits less the initial outlay. u This is wealth created for a multiple period. u In theory NPV of the firm divided by the number of shares gives you the intrinsic value of the stock.

The Capital Budgeting Process u Steps involved in the capital investment process: u Establish Goals u Develop Strategy u Search for Investment Opportunities u Evaluate Investment Opportunities u Select Investments u Implement and Monitor u Post-Audit

What Makes a Capital Investment Attractive? u An attractive capital investment: u Fits the strategy of the firm u Within an appropriate risk level u Has a positive net present value or economic profit across time

Summary u A corporation has many stakeholders with conflicting desires. u Wealth creation for the shareholders is our goal. u Accounting income is not a sufficient measure of performance because it ignores risk and the cost of the invested funds. u Economic profit and net present value are two ways we measure wealth creation in a single period and multiple periods. u Capital projects create most of the wealth for the firm but not all projects are equal or should even be considered. u Strategy and competive advantage should guide the capital budgeting process.