Capital Budgeting Valuation

Financial Analysis for Today's Investment Projects

H. Kent Baker, Philip English, H. Kent Baker, Philip English

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118044568
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Finanzas

An essential guide to valuation techniques and financial analysis

With the collapse of the economy and financial systems, many institutions are reevaluating what they are willing to spend money on. Project valuation is key to both cost effectiveness measures and shareholder value.

The purpose of this book is to provide a comprehensive examination of critical capital budgeting topics. Coverage extends from discussing basic concepts, principles, and techniques to their application to increasingly complex, real-world situations. Throughout, the book emphasizes how financially sound capital budgeting facilitates the process of value creation and discusses why various theories make sense and how firms can use them to solve problems and create wealth.

• Offers a strategic focus on the application of various techniques and approaches related to a firm's overall strategy
• Provides coverage of international topics based on the premise that managers should view business from a global perspective
• Emphasizes the importance of using real options

Comprised of contributed chapters from both experienced professionals and academics, Capital Budgeting Valuation offers a variety of perspectives and a rich interplay of ideas related to this important financial discipline.

Chapter 1
Capital Budgeting: An Overview

H. KENT BAKER

University Professor of Finance and Kogod Research Professor, Kogod School of Business, American University

PHILIP ENGLISH

Assistant Professor of Finance, Kogod School of Business, American University

INTRODUCTION

Capital budgeting refers to the process that managers use to make decisions about whether long-term investments or capital expenditures are worth pursuing by their organizations. In other words, capital budgeting is the process of planning, analyzing, selecting, and managing capital investments. The basic notion is that managers use the capital, usually long-term funds, raised by their firms to invest in assets (also called capital goods) that will enable the firm to generate cash flows for at least several years into the future. Typical investments include replacements of existing assets and expansion of existing or new product lines. Capital budgeting is one of the most challenging tasks facing management because it concerns the investment decision, which deals with allocating funds over time in order to achieve a firm's objectives. For most companies, the investment decision has a greater impact on value than does the financing decision, which deals with acquiring needed funds. However, both investment and financing decisions are intertwined and at the heart of financial management.

Capital budgeting has a long-term focus that provides a link to an organization's strategic plan, which specifies how an organization expects to accomplish long-term strategic goals. Many capital investments require a substantial commitment of a firm's resources that directly affect firm performance, competitive position, and future direction. Because capital investments often commit a large amount of funds for lengthy periods, they are not only difficult or costly to reverse but also difficult to convert to more liquid assets (Migliore and McCracken, 2001). Also, errors in capital budgeting can affect the firm over a long horizon.

Capital Budgeting Process

The capital budgeting process is a system of interrelated steps for generating long-term investment proposals; reviewing, analyzing, and selecting them; and implementing and following up on those selected. This process is dynamic because changing factors in an organization's environment may influence the attractiveness of current or proposed projects. Although no universal consensus exists on the process, Baker and Powell (2005, p. 196) view capital budgeting as a six-stage process:

1. 1. Identify project proposals. Develop and provide preliminary screening of project proposals.
2. 2. Estimate project cash flows. Identify and estimate the incremental, after-tax cash flows for a proposed project.
3. 3. Evaluate projects. Determine the financial viability of a project by evaluating the project's incremental after-tax cash flows.
4. 4. Select projects. Choose the projects that best meet the selection criteria.
5. 5. Implement projects. Determine the order of implementation, initiate, and track the selected projects.
6. 6. Perform a postcompletion audit. Periodically compare the actual cash flows for the project to the prior estimates in the capital budgeting proposal.

All stages of the capital budgeting process are important. The failure to properly complete any stage of the capital budgeting process could have detrimental results. The process starts with the identification of investment opportunities and the preliminary screening of project proposals. Without having potentially viable projects that meet the firm's strategic concerns, the remainder of the capital budgeting process would be meaningless.

Arguably, the most challenging phase of this process is estimating project cash flows because no later stage in the process can fully overcome the inevitable forecasting errors resulting from managers dealing with an uncertain future. Miller (2000, p. 128) notes that “In the real world, virtually all numbers are estimates. The problem with estimates, of course, is that they are frequently wrong.”

Despite the importance of estimating project cash flows, the financial literature tends to emphasize the evaluation and selection stages. Improper valuation can lead to incorrect decisions despite the identification of potentially viable projects and accurate estimation of their cash flows. Although many capital budgeting techniques are available for evaluating capital budgeting projects, the best methods typically recognize the amount, the time value, and the riskiness of a project's cash flows.

Selecting capital investments involves a unique set of challenges. Allocating funds among alternative investment opportunities is crucial to a firm's success and is especially important in terms of financial consequences. Capital assets represent a major portion of the total assets of many firms. The selection stage is particularly important in the face of limited investment funds, an area of capital budgeting known as capital rationing. While some organizations have sufficient resources available to fund all desirable projects, most face a scarcity of capital that enables them to fund some projects but not others. Capital rationing, whether internally or externally imposed, makes investment choices more difficult because the firm must reject some investments. However, capital rationing can also reduce and control agency costs. Capital rationing can avoid both overinvestment in low-return projects that occurs when managers have private information and incentives for controlling more assets and managerial understatement of current performance in order to lower their future performance targets.

After approving a capital investment, managers must implement and closely monitor the project. This stage involves raising capital to finance the project, authorizing expenditures, and monitoring projects in progress.

The final stage in the capital budgeting process is to conduct a postcompletion audit. Managers, however, do not engage in postcompletion auditing of all projects because doing so could be costly or impractical. Consequently, large capital budgeting projects tend to be the primary targets for such audits. The most important perceived benefits relate to the enhancement of organizational learning. Conducting postcompletion audits can provide important feedback for current and future investments, and consequently make capital investments more effective (Neale, 1991; Pierce and Tsay, 1992). For example, these audits may identify systematic biases in making cash flow estimates, which may lead to improved cash flow estimates and to better decision making in the future. Thus, postcompletion audits provide a means for holding managers accountable for their estimates and decisions involving capital investments.

Financial Objective of the Firm

Before carrying out the capital budgeting process, management should first define the organization's financial objective. The conventionally advocated capital investment objective, especially in large, listed corporations, is to make long-term investment decisions that will maximize owners’ wealth. That is, senior managers of publicly held companies should select those projects that they believe will maximize the firm's value for its shareholders. As Jensen (2001, p. 8) notes, “This Value Maximization proposition has its roots in 200 years of research in economics and finance.” Yet, this financial objective seems to be inconsistent with some empirical observations such those in Francis (1980).

The main contender to shareholder wealth maximization is stakeholder theory, which asserts that management decisions should consider stakeholder interests wider than those of the stockholders alone. This view contends that firms should pay attention to all their constituencies because many different classes of stakeholders contribute to their success. Beyond financial claimholders, stakeholders may include managers, employers, customers, suppliers, local communities, and the government. Survey evidence by Grinyer, Sinclair, and Ibrahim (1999) is consistent with the notion that some managers do not prefer maximization of stockholders’ wealth as the main objective of the firm. Cloninger (1995) proposes the formal abandonment of a stockholder wealth maximizing criterion.

While stakeholder theory has intuitive appeal, recognizing a wide range of stakeholders introduces possible difficulties associated with multiple objectives. Trying to maximize multiple objectives, some of which may conflict, would leave the managers in a quandary about whose interests should take priority—stockholders or other stakeholders.

In theory, capital projects should be analyzed in terms of shareholder wealth maximization. Based on this assumption, managers should undertake all investment projects with a positive net present value (NPV) or an internal rate of return (IRR) higher than the prescribed hurdle rate. By so doing, managers should enhance firm market value and consequently increase owners’ wealth. In practice, management should not necessarily accept a project just because it appears financially attractive. Achieving the financial objective of shareholder wealth maximization entails developing a business strategy. Success in capital investment affects the extent to which a company can achieve its strategic objectives. Investment decisions do not occur in a vacuum but are embedded in a company's strategy. Thus, strategy limits the se...

Table of contents

• Cover
• Table of Contents
• Series
• Title
• Copyright
• Acknowledgments
• Chapter 1: Capital Budgeting: An Overview
• Part I: Foundation and Key Concepts
• Part II: Capital Investment Choice
• Part III: Project Cash Flows and Inflation
• Part IV: Risk and Investment Choice
• Part V: Real Options and Project Analysis
• Part VI: Estimating the Project Cost of Capital
• Part VII: Special Topics
• Answers to Discussion Questions
• Index
• End User License Agreement