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.

Stakeholders and Competing Desires Stakeholder: What their goals are (what they want): Managers High Salary and perquisites. Creditors Low risk, return of their money and interest Customers Low prices and lots of features Employees High salaries, job security Suppliers High prices and long relationships Society Good citizenship and taxes Owners Dividends or stock appreciation

Economic Profit – A Single Period Measure of Wealth Revenues -Expenses Accounting Profit Required Return (Computed as RRR * Investment) Economic Profit (this is wealth created for a single period)

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)

Other Definitions of Economic Profit Economic 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 The point here is simply to relate other common measures of success to economic profit. Other things being equal, a higher ROE or higher ROTA leads to higher economic profit. However, it does not follow that maximizing ROE or maximizing ROTA maximizes economic profit and wealth. This is illustrated on the next transparency.

Profitability measures & choice Accounting income Required income (12%) Economic profit $50 $100 $150 24 60 . $26 $40 ROTA ROE 5% 4% 25% 20% Assets Equity $1,000 $2,500 $5,000 200 500 1,000 Purpose is to illustrate the use of economic profit as a decision criterion, and relate it to ROTA and ROE. First ask the participant to fill in the blanks on the transparency: Required income = $120, Economic profit = $30, ROE = $15, and ROTA = 3% If people have trouble with $2,500 as the optimal size, note that adding $500 more equity gets $30 more income, for an ROE of 6% on the marginal investment. That is much less than the 12% required return. Other things being equal higher ROTA and higher ROE are good. However, that does not give us a criterion for making decisions when other things (I.e, amount invested) are not equal. Economic profit does tell us what to do.

Net Present Value – A Multi-period Measure of Wealth 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.

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

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

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.