Capital Budgeting Summary
Capital budgeting is the process of evaluating a company’s potential investments and deciding which ones to accept. A company’s market value added (MVA) is the sum of all its projects’ net present values (NPVs). Basically, one can calculate the free cash flows (FCFs) for a project in much the same way as for a firm. When a project’s free cash flows are discounted at the appropriate risk-adjusted rate, the result is the project’s value. One difference between valuing a firm and a project is the rate that is used to discount cash flows. For a firm, it is the overall weighted cost of capital, while for a project, it is r, the project’s risk adjusted cost of capital. Subtracting the initial cost of a project gives the NPV of the project. If a project has a positive NPV, then it adds value to the firm. In this chapter, an overview of the capital budgeting and the basic techniques used to evaluate potential projects, are discussed.
Overview of Capital Budgeting
Capital budgeting is the decision process that managers use to identify projects that add to the firm’s value, and as such it is perhaps the most important task faced by financial managers and their staffs. It is important because of the following reasons:
1) A company’s capital budgeting decisions define its strategic direction. The reason is that moves into new products, services, or markets must be preceded by capital expenditures;
2) Results of capital budgeting decisions usually continue for many years, reducing the flexibility of decisions;
3) Poor capital budgeting can have serious financial consequences. For example, if a company invests too much, it will waste investors’ capital on excess capacity. On the other hand, if it does not invest enough, its equipment and computer software may not be sufficiently modern to enable it to produce competitively. In addition, inadequate capacity may cause the company to lose market share to rival companies, and regaining lost customers requires heavy
Overview of Capital Budgeting
Capital budgeting is the decision process that managers use to identify projects that add to the firm’s value, and as such it is perhaps the most important task faced by financial managers and their staffs. It is important because of the following reasons:
1) A company’s capital budgeting decisions define its strategic direction. The reason is that moves into new products, services, or markets must be preceded by capital expenditures;
2) Results of capital budgeting decisions usually continue for many years, reducing the flexibility of decisions;
3) Poor capital budgeting can have serious financial consequences. For example, if a company invests too much, it will waste investors’ capital on excess capacity. On the other hand, if it does not invest enough, its equipment and computer software may not be sufficiently modern to enable it to produce competitively. In addition, inadequate capacity may cause the company to lose market share to rival companies, and regaining lost customers requires heavy