Capital Budgeting Techniques
The value of a company today is the present value of all its future cash flows, where these future cash flows come from assets that are already in place and from future investment opportunities. These future cash flows are discounted at a rate that represents investors’ assessments of the uncertainty that they will flow in the amounts and when expected. Management makes decisions by evaluating which capital projects, if any, are expected to enhance the value of the company. This process is referred to as capital budgeting.
The capital budgeting decisions for a project requires analysis of: (1) the project’s future cash flows; (2) the degree of uncertainty associated with the project’s future cash flows; and (3) the value of the project’s future cash flows considering their uncertainty. The estimation of cash flows involves estimating with a project’s incremental cash flows, comprising changes in operating cash flows (change in revenues, expenses, and taxes), and changes in investment cash flows (the firm’s incremental cash flows from the acquisition and disposition of the project’s assets).
The degree of uncertainty, or risk, is reflected in a project’s cost of capital. The cost of capital is what the company must pay for the funds to finance its investments. The cost of capital may be an explicit cost (for example, the interest paid on debt) or an implicit cost (for example, the expected price appreciation of its shares of common stock). ...