Capital Budgeting

The corporation is comprised of a portfolio of assets.  Management of the portfolio requires continual assessment of the relative value of current and prospective assets.
 
 

The investment opportunity set includes all the investment opportunities available to the corporation.  However, corporations, like individuals, can never know all the elements in their investment opportunity set.  Thus, intelligence about the elements of this investment opportunity set is one of the critical determinants of success.  Management must be judged, therefore, not only on their ability to value investment projects, but on their ability to obtain intelligence about the elements of the investment opportunity set.

This intelligence can be gathered from a wide range of sources, including from within various divisions of the corporation (research and development, marketing and sales, operations, finance, human resources, etc.).  This is an area where corporations could potentially make very effective use of college interns, who are often very creative at identifying potential investment opportunities.  Corporations can also make use of consultants from a wide range of backgrounds in both identifying new opportunities and rethinking existing configurations of assets.
 
 

Identification of new investment opportunities (locating elements in the largely invisible investment opportunity set) can come through brainstorming sessions.  However, once the ideas are on the table, it becomes important to value the associated investment projects.  This requires number gathering and number crunching.  Ultimately, the value of the project is a complex combination of the cash flows generated by the project (both positive and negative, and including impacts on existing cash flows, such as from enhancing or cannibalizing sales of existing products and services) and the cost of financing the project.  The cost of financing is overdetermined by a large array of factors, including the corporation's business and political associations, the perceived relative risk of the projects to be financed (and the firm as a whole), and the sophistication of the financial institutions from which the funds to finance the project will be acquired (or the degree to which the firm can self-finance through retained earnings).