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Part 2. The Investment Decision

2. Capital Budgeting Under Conditions Of Certainty

Introduction

The decision to invest is the mainspring of financial management. A project's acceptance should produce future returns that maximise corporate value at minimum cost to the company.

We shall therefore begin with an explanation of capital budgeting decisions and two common investment methods; payback (PB) and the accounting rate of return (ARR).

Given the failure of both PB and ARR to measure the extent to which the utility of money today is greater or less than money received in the future, we shall then focus upon the internal rate of return (IRR) and net present value (NPV) techniques. Their methodologies incorporate the time value of money by employing discounted cash flow analysis based on the concept of compound interest and a firm's overall cut-off rate for investment.

For speed of exposition, a mathematical derivation of an appropriate cut-off rate (measured by a company's weighted average cost of capital, WACC, explained in Part One) will be taken as given until Chapter Three of the follow up SFM text. For the moment, all you need to remember is that in a mixed market economy firms raise funds from various providers of capital who expect an appropriate return from efficient asset investment. And given the assumptions of a perfect capital market with no barriers to trade (also explained in Part One) managerial investment decisions can be separated from shareholder preferences for consumption or investment without compromising wealth maximisation, providing all projects are valued on the basis of their opportunity cost of capital.

As we shall discover, if the firm's cut-off rate for investment corresponds to this opportunity cost, which represents the return that shareholders can earn elsewhere on similar investments of comparable risk:

Projects that generate a return (IRR) greater than their opportunity cost of capital will have a positive NPV and should be accepted, whereas projects with an inferior IRR (negative NPV) should be rejected.

2.1. The Role of Capital Budgeting

The financial term capital is broad in scope. It is applied to non-human resources, physical or monetary, short or long. Similarly, budgeting takes many forms but invariably comprises the detailed, quantified planning of a scarce resource for commercial benefit. It implies a choice between alternatives. Thus, a combination of the two terms defines investment and financing decisions which relate to capital assets which are designed to increase corporate profitability and hence value.

To simplify matters, academics and practitioners categorise investment and financing decisions into long-term (strategic) medium (tactical) and short (operational). The latter define working capital management, which represents a firm's total investment in current assets, (stocks, debtors and cash), irrespective of their financing source. It is supposed to lubricate the wheels of fixed asset investment once it is up and running. Tactics may then change the route. However, capital budgeting proper, by which we mean fixed asset formation, defines the engine that drives the firm forward characterized by three distinguishing features:

Longer term investment; larger financial outlay; greater uncertainty.

Combined with inflation and changing economic conditions, uncertainty complicates any investment decision. We shall therefore defer its effects until Chapter Four having reviewed the basic capital budgeting models in its absence.

With regard to a strategic classification of projects we can identify:

- Diversification defined in terms of new products, services, markets and core technologies which do not compromise long-term profits.

- Expansion of existing activities based on a comparison of long-run returns which stem from increased profitable volume.

- Improvement designed to produce additional revenue or cost savings from existing operations by investing in new or alternative technology.

- Buy or lease based on long-term profitability in relation to alternative financing schemes.

- Replacement intended to maintain the firm's existing operating capability intact, without necessarily applying the test of profitability.

 
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