Financial Economics

25

CAPITAL EXPENDITURE PLANS IN A RISKY WORLD

Decisions regarding long-term investment projects are referred to as capital budgeting decisions. In Chapter 6 we discussed how management of a firm should make capital budgeting decisions in a perfect capital market when future cash flows can be forecast with certainty. In this and the next chapter we consider projects with risky future cash flows. Such projects require that managers analyze the following factors:

• Each project's incremental future cash flows
• The probability distributions of these cash flows
• The present value of the cash flows, discounted according to the risks they present

In Chapter 6 we saw that a project's incremental cash flows comprise (1) operating cash flows (the change in the revenues, expenses, and taxes) and (2) investment cash flows (the acquisition and disposition of the project's assets). Given estimates of incremental cash flows for a project and an appropriate discount rate, we looked at alternative techniques to select the best of the available projects.

In deciding whether a project increases shareholder wealth, managers must weigh both its costs and its benefits. The costs are the cash flows necessary to create the project (the investment outlay) and the opportunity costs of not otherwise being able to use the cash tied up in the project. The benefits are the future cash flows expected to be generated by the project. But the future is unknown and therefore future cash flows are exposed to risk. ...