Chapter 1: Long-term Financial
Decisions

Why are capital budgeting decisions important to the firm,
society, and to you personally in your career or private life?
 Three things that make capital budgeting decisions
important:
 1 Capital projects involve large amounts of money.
 2 Capital projects are typically hard (or costly) to
reverse.
 3 Capital projects and related financing are the source
of all wealth to the firm and its stockholders.
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Stakeholders and Competing Desires

Stakeholder:
What their goals are (what they want):
Managers
 Creditors
 Customers
 Employees
 Suppliers
 Society
 Owners
High Salary and perquisites.
Low risk, return of their money and interest
Low prices and lots of features
High salaries, job security
High prices and long relationships
Good citizenship and taxes
Dividends or stock appreciation

2
Economic Profit – A Single Period
Measure of Wealth
 Economic
Profit:
Revenues
-Expenses
Accounting Profit
Required Return (Computed as RRR * Investment)
Economic Profit (this is wealth created for a single period)
3
Wealth Creation versus
Accounting Profit
A
firm should maximize economic profit or
wealth instead of profits because:
 Wealth
includes risk while profit does not.
 Wealth is three dimensional
 (revenues, cost and risk)
 Profit is two dimensional
 ( revenues and cost)
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Other Definitions of
Economic Profit
profit = accounting income –
opportunity cost of equity
 Economic profit = Equity X (ROE – Ke)
where Ke is the required return on
equity
 Economic profit = Assets X (ROTA - Ka)
where Ka is required return on assets
 Economic
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Profitability measures &
choice
Accounting income
Required income (12%)
Economic profit
$50
24
$26
ROTA
ROE
5%
25%
Assets
Equity
$100
60
$40
$150
.
4%
20%
$1,000 $2,500 $5,000
200
500 1,000
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Net Present Value – A Multi-period
Measure of Wealth
 Net
Present Value:
Take the present value of a series of future
economic profits less the initial outlay.
This is wealth created for a multiple period.
In theory NPV of the firm divided by the
number of shares gives you the intrinsic
value of the stock.
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The Capital Budgeting Process

Steps involved in the capital investment process:
 Establish Goals
 Develop Strategy
 Search for Investment Opportunities
 Evaluate Investment Opportunities
 Select Investments
 Implement and Monitor
 Post-Audit
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What Makes a Capital Investment
Attractive?
 An
attractive capital investment:
Fits the strategy of the firm
Within an appropriate risk level
Has a positive net present value or
economic profit across time
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Summary






A corporation has many stakeholders with conflicting desires.
Wealth creation for the shareholders is our goal.
Accounting income is not a sufficient measure of performance
because it ignores risk and the cost of the invested funds.
Economic profit and net present value are two ways we measure
wealth creation in a single period and multiple periods.
Capital projects create most of the wealth for the firm but not all
projects are equal or should even be considered.
Strategy and competive advantage should guide the capital
budgeting process.
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