THE CAPITAL BUDGETING DECISION
Capital budgeting decisions
are central to the company`s success or failure. For example, in the late
1980s, the Walt Disney Company committed
to construction of a Disneyland Paris theme park at a total cost of well
over $2 billion. The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to
reorganize in May 1994. Instead of providing profits on the investment,
accumulated losses on the park by that date were more than
$200 million.
Contrast that with Boeing`s
decision to “bet the company” by developing the 757 and 767 jets. Boeing`s
investment in these planes was $3
billion, more than double the total value of stockholders` investment as
shown in the company`s accounts at the time. By 1997, estimated cumulative profits from this investment were
approaching $8 billion, and the planes were still selling well.
Disney`s decision to invest
in Euro Disney and Boeing`s decision to invest in a new generation of airliners
are both examples of capital budgeting
decisions. The success of such decisions is usually judged in terms of value.
Good investment projects are worth more than they cost. Adopting such projects increases the value
of the firm and therefore the wealth of its shareholders. For example, Boeing`s
investment produced a stream of cash
flows that were worth much more than its $3 billion outlay.
Not all investments are in
physical plant and equipment. For example, Gillette spent around $300 million
to market its new Mach3 razor. This
represents an investment in a nontangible asset brand recognition and acceptance. Moreover,
traditional manufacturing firms are not the only ones that make important capital budgeting decisions. For
example, Intel`s research and development expenditures in 1998 were more than
$2.5 billion.4 This investment in future products and product
improvement will be crucial to the company`s ability to retain its existing
customers and attract new ones.
Today`s investments provide benefits in the future. Thus
the financial manager is concerned not solely with the size of the benefits but
also with how long the firm must wait
for them. The sooner the profits come in, the better. In addition, these
benefits are rarely certain; a new project may
be a great success but then again it could be a dismal failure. The
financial manager needs a way to place a value on these uncertain future benefits.
We will spend considerable time in later material on
project evaluation. While no one can guarantee that you will avoid disasters
like Euro Disney or that you will be
blessed with successes like the 757 and 767, a disciplined, analytical approach
to project proposals will weight the odds in your favor.
CAPITAL BUDGETING
DECISION Decision
as to which real assets the firm should acquire.
FINANCING DECISION
Decision as to how to raise the money to pay for
investments in real assets.
Category: Cash flows
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