Summary of “The Capital Budgeting Decision” Book
CHAPTER 1INVESTMENT DECISIONS AND CORPORATE OBJECTIVE
Capital budgeting decision process must take consideration four basic factors:Time value of moneyRisk considerationsAlternative investmentsFuture opportunities
THE STATE OF BUSINESS PRACTICE
The formula (1+r)-n used to transform future value of money into their present valueequivalents. The interest rate (r) either takes into consideration the pure time value (using arisk free
rate), the risk of the corporation (the firm’s WACC), and the risk of the operating
unit (plant or division), the risk of the specific project being evaluated or the risk of thespecific cash flow component.
TIME, RISK, AND THE RISK-RETURN TRADE OFF
The decision that we take today can affect the cash flow for many future time periods and theoutcomes of the actions are uncertain, so we need to formulate decision rules that take a risk and time value into consideration systematic fashion. Uncertainty makes the decision-makerface alternatives that involve trade-offs of less return and less risk or more return and morerisk.
THREE BASIC GENERALIZATIONS
In the financial decision, there are three basic generalizations that are useful:First: Investor more prefer more return (cash and value) to less, all other things beingequal (risk is held constant)Second: Investor is risk averse. They prefer less risk (a possibility of loss) to morerisk and have to be paid to undertake risky endeavors.Third: Cash to be received today is preferred to the same amount of cash to bereceived in the future.
CASH FLOWS VERSUS EARNINGS
A decision may be characterized by its effect on accounting earnings, as well as by itsincremental cash flows. Future cash flows were consider to be a relevant measure of theimpact of a decision on the firm and will use anticipated cash flows as the primary input inthe decision to be analyzed.