In Chapter 6 we discussed capital budgeting decisions. As we explained, the firm's managers should invest only to increase the value of the owners’ interests. When a firm invests in new assets, it expects the future cash flows to be greater than without this new investment. The difference between the cash flows of the company with the investment project, compared over the same period of time to the cash flows of the company without the investment project is referred to as the project's incremental cash flows.
The change in the value of the company resulting from an investment can be broken down two components:
The effect on the value of the company can then be evaluated using the techniques described in Chapter 6 (in the certainty case) and Chapters 25 and 26 in the more realistic case where management is exposed to risk.
In the simplest form of investment, there will be a cash outflow when the asset is acquired and there may be either a cash inflow or an outflow at the end of its economic life. In most cases there are also changes in operating cash flows to take into account—the investment will ...