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, analysis of alternative ways to achieve more productivity and innovation, and oversight of implementation (and occasional termination) of projects.

The investment opportunity set includes all the investment opportunities available to the corporation.  Mutually exclusive projects must be compared to determine which project will be selected, since firm managers face constraints on total investment (no firm can finance every NPV > 0 project). If the firm is comparing project A to project B and can only choose one of them (which is the definition of mutually exclusive), then it must also consider the opportunity cost of abandoning one of the projects in favor of the other. For example, if Walmart must choose between installing a backup generator or having solar panels installed and storing extra energy in batteries, then either of these choices has the burden of not only being deemed net present value positive but must also beat the return of the other project (because they are mutually exclusive). In reality, there are always a large number of alternative investments, including many that are mutually exclusive and some that are complementary (where investment project G and project H, if both are implemented, results in higher value for both projects). Finding these complementary projects can enhance the value creating activities of the firm. 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.  Another critical element is research and development, where attempts are made to open up new elements in the opportunity set. Management must hire, monitor, and motivate the talent whose responsibility is intelligence gathering and analysis and research and development. 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 -- see the Apple example in the next section) 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 (collected via issuances of equity and/or debt) to finance the project will be acquired and/or the degree to which the firm can self-finance through retained earnings.

Expenditures to fund intelligence gathering on future projects (and related markets) and research and development are not costs that should be included in valuation analysis of those projects. From the standpoint of the project, these costs are part of the corporation's past (occurring prior to t = 0, the period in which project implementation starts to generate expenses, including project-related capital expenditures). These past costs are properly described as sunk costs. The only costs that are elements in the valuation of a project are those costs that are only incurred if the project is approved resulting in project related cash outflows, including any property, plant, and equipment that must be purchased in order to carry out the project, and future positive cash inflows. Net cash flows must include incidental costs incurred due to the implementation of the project. For instance, when Apple begins selling the iPhone 7, then some customers who had considered buying the iPhone 6 may change their mind and buy the 7 instead. One should not count all of the project related sales of iPhone 7 as an addition to Apple's total sales. The incidental effect of lost iPhone 6 sales (and other negative incidental effects) should be subtracted from total iPhone 7 sales to get the net increase in sales resulting from the iPhone 7 project. On the other hand, if iPhone 7 sales are positively correlated with increased sales of accessories or other Apple products, then these additional revenues should be added to the direct effect of projected iPhone sales - incidental costs to obtain the project related sales (Total iPhone 7 sales - incidental costs + incidental benefits). Think of t=0 as the moment of birth of the project and only direct and indirect (incidental effect*) cash flows that are the result of the project's birth and life are relevant to its value.

* Incidental effects refers to indirect effects on corporate cash flows. The concept of externalities refers to public costs or public benefits that do not (noticeably) impact the company's cash flows or, more accurately, the firm's financial statements.

Corporate boards of directors and the management they employ are expected to approve and implement projects that are net present value positive (NPV > 0). Net present value depends on the discounted future cash flows generated by the project, where the discount rate is a function of investor required returns (on equity or loans) and investment/merchant banking fees and discounts that lower the firm's take out of the gross proceeds of issuing equity shares or bonds. It is assumed that the required return is a function of the psychology of relevant financial market participants (where the set of participants in equity markets is assumed to be much larger and, in most cases, less informed than bond investors, who tend to be financial corporations and high net worth individuals). Psychology plays a role in trading securities and, inevitably, impacts investors willingness to pay (or not pay) certain prices for equity shares and/or bonds. Since investors can be a bit bi-polar, with serious mood swings from pessimism to exuberance, then it matters a good deal when corporate management decides to raise funds. During periods of exuberance in the stock market, equity share sales would tend to raise more money than during less enthusiastic times. Thus, for any given flotation costs, corporate management can gain more money and face lower required returns on equity shares than during more depressive market conditions. When markets are depressed, on the other hand, bond prices will tend to be higher and required returns on bonds lower, making borrowing more attractive, at least from the cost side. On the other hand, a depressed stock market may be, at least in part, reflective of depressed product markets, which could result in lower future cash flows for the firm, making default risk higher and perhaps leading to upward pressures on required bondholder returns.
In any event, corporate management should use appropriate discount rates, based on current and expected future market conditions. Projecting forward low current required rates of return could lead to poor estimates of the project NPVs (overestimation errors). Overestimation of NPVs could lead to poor capital budgeting decisions. Assuming good estimates of required returns on equity and bonds, it is assumed that net present value projects lead to higher firm valuation, which benefits shareowners. As valuation increases, indicating a higher value for the assets owned by the shareowners, then share prices should increase, creating the potential for capital gains for shareowners, and free cash flow available for distribution (directly in the form of dividends or indirectly in the form of stock buybacks) to shareowners should also increase.

Evidence shows that there is a negative correlation between corporations gaining a positive reputation for sustainable development or green or socially responsible capital budgeting projects or sourcing and the required return for funding the corporation's projects, more generally. This means that a substantial (and certainly significant) number of investors are sensitive to these social factors, such that they are willing to pay a higher price for the equity shares and bonds of firms with a positive reputation. Thus, positive social reputation can lower a firm's cost of capital.

Copyright  2012-2015, Satya Gabriel, Economics Department, Mount Holyoke College.