1. Chapter 1 Introduction to Capital Budgeting
Capital Budgeting & Investment Analysis By Alan Shapiro

2. Introduction to Capital Budgeting
The most important topic in corporate finance is the analysis of capital expenditures
Decisions to invest capital determines the firms future course and hence its market value
Capital Budgeting decision is the allocation of funds among alternative investment opportunities

3. The capital Budgeting decision
Capital expenditure is any cash outlay expected to generate cash flows lasting longer than one year.
Advertising: Brand names

4. The objective of capital budgeting
The aim is to maximize the wealth of its shareholders
People prefer more wealth
Defer consumption and invest
Risk aversion: Bond vs. stock

5. The importance of Shareholder Value
Shareholders are the legal owners of the firm and management has a fiduciary obligation to act in the shareholders’ best interests.
Value gap: The difference between the actual value of the company and the value if it were optimally managed.
Board of directors becoming more active.

6. The importance of Shareholder Value cont.
Maximizing shareholder value is the only way to maximize the economic interests of all stakeholders over time
Attract equity capital seeking to grow
Maximizing shareholder wealth is tantamount to maximizing the firm’s share price

7. Basic Drivers of share value
Shareholder value depends on cash flow, time, and risk
The more cash that shareholders receive and the sooner they expect to receive that cash, the better of they are.
Accounting profits not associated with cash flows are of no value to investors

8. Basic Drivers of share value cont.
Enhancing the company’s cash flow generating ability
Investors discount cash to be received in the future, reducing the value today
People prefer present consumption over consumption in the future

9. Basic Drivers of share value cont.
TVM: a dollar today is worth more than a dollar in the future
PV and FV
The interest rate at which future cash flows are discounted increases with risk
Investors are generally risk averse; all things being equal, they prefer less risk to more risk
Future cash flows are discounted for both TVM and degree of risk involved.

10. Capital Budgeting Principles and criteria
Take all projects that would increase shareholder wealth
Reject all projects that would decrease shareholder wealth
Place higher weight on earlier cash flows
Penalize more heavily the expected cash flows of riskier projects

11. The capital budgeting process
Sometimes a project arises naturally, as when a machine tool wears out and must be replaced
R&D
Decide whether products involved are commercially viable
Size of market
Consultation with people in engineering, production, marketing and transportation

12. The capital budgeting process cont.
Begin with forecasts of future sales
Convert into production forecasts
Cost of obtaining capital
Capital budgets cannot remain static and should respond to changes
Oil prices and drilling
Labor costs

13. Classifying capital budgeting projects
Investment categories
Equipment replacement
Expansion to meet growth in existing products
Expansion generated by new products
Projects mandated by law
* Risk

14. Project interaction Independent projects Mutually exclusive projects
Acceptance or rejection are independent of one another. They bear no relation to one another
The firm could accept one, both or none.
Mutually exclusive projects
The acceptance of one precludes the selection of any alternative projects
Contingent projects
One whose acceptance depends on the adoption of another project

15. Summary and conclusions
The ultimate aim of capital budgeting is to maximize the market value of the company’s common stock in the long run and thereby wealth of shareholders
Future CFs must be discounted to account for time and risk
The larger the dollar amount involved, the more scrutiny of the investment there will be