Capital Budget

Chapter 3: Measurement of Return (Capital Budgeting)

Should we build this plant?

Basic principles of Investing
Invest in projects that yield a return greater than the minimum acceptable hurdle rate – The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) – Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects Choose a financing mix that minimizes the hurdle rate and matches the assets being financed If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics

Types of Capital Budgeting Decisions
Any decision that requires the use of resources (financial or otherwise) is a project – Broad strategic decisions – Entering new areas of business – Entering new markets – Acquiring other companies Tactical decisions Management decisions – The product mix to carry – The level of inventory and credit terms Decisions on delivering a needed service – Lease or buy a distribution system – Creating and delivering a management information system

Basic Principles of Return
Use cash flows rather than earnings. You cannot spend earnings. Use “incremental” cash flows relating to the investment decision, i.e., cash flows that occur as a consequence of the decision, rather than total cash flows Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later. The Return Mantra: “Time-weighted, Incremental Cash Flow Return”

Nominal vs Real Cash Flows; Ke Vs WACC
A project can be analyzed in nominal terms (in which case inflation is incorporated into both your cash flows and your discount rate) or in real terms. When inflation is high and volatile, analysts may find it... [continues]

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