Long-term investment decisions are important because substantial amounts of funds are often committed for extended periods. They are difficult because they entail forecasts of uncertain future events that must be relied on heavily.
• Capital budgeting is the process of planning expenditures that generate cash flows expected to extend beyond 1 year. Several different types of investment projects may be involved, including replacement projects, or maintenance of business projects; cost reduction projects to replace obsolete plant and equipment; mandatory nonrevenue-producing safety and environmental projects; and expansion projects to increase the availability of existing products and services.
• In all cases, the focus is on incremental cash flows, or the period-by-period changes in net cash flows that are due to the investment project. The most common tool for project valuation is net present-value (NPV) analysis, where NPV is the difference between project marginal revenues and marginal costs, when both are expressed in present-value terms. The conversion to present-value terms involves use of an appropriate discount rate, or cost of capital.
• Alternative decision rules include the profitability index (PI), or benefit/cost ratio; internal rate of return (IRR), or discount rate that equates the present value of receipts and outlays; and the payback period, or number of years required to recover the initial investment.
• Managers must be aware of the net present-value profile for individual projects, a graph that relates the NPV for each project to the discount rate used in the NPV calculation. A reversal of project rankings occurs at the crossover discount rate, where NPV is equal for two or more investment alternatives.
• To properly value cash flows over the life of a project, the cost of capital funds must be determined. The component cost of debt is the interest rate that investors require on debt, adjusted for taxes. The component cost of equity is the rate of return stockholders require on common stock. This includes a risk-free rate of return to compensate investors for postponing their consumption, plus a risk premium to compensate them for risk taking. The riskiness of a given stock is measured in terms of the firm's beta coefficient, a measure of return variability.
• The weighted-average cost of capital is the marginal cost of a composite dollar of debt and equity financing. The proper set of weights to employ in computing the weighted-average cost of capital is determined by the firm's optimal capital structure, or combination of debt and equity financing that minimizes the firm's overall weighted-average cost of capital.
• The optimal capital budget is the funding level required to underwrite a value-maximizing level of new investment. Graphically, the optimal capital budget is determined by the intersection of the investment opportunity schedule (IOS), or pattern of returns for all of the firm's potential investment projects, and the marginal cost of capital (MCC), or IRR schedule.
• An intuitive and increasingly popular method for judging the efficiency of the firm's capital budgeting process is called economic value-added (EVA©) analysis. EVA© is an accounting-based estimate of the profit added through the firm's capital budgeting process. If net income fails to provide an accurate indication of economic performance, cash flow numbers may offer better insight regarding firm or divisional performance. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is one such cash flow measure that is commonly employed. To ensure that funds for necessary capital expenditures will be available, prudent managers often focus on free cash flow, or EBITDA minus the cost of essential plant and equipment.
• The postaudit is the final step in the capital budgeting process and consists of a careful examination of actual and predicted results, coupled with a detailed reconciliation of any differences.
Taken as a whole, the capital budgeting process is one in which the principles of marginal analysis are applied in a systematic way to long-term investment decision making. As such, the process provides further evidence of managers actually going through the process of value maximization.
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