Similarities between Capital Budgeting and Security Valuation

Once a potential capital budgeting project has been identified, its evaluation involves the same steps
that security analysts use.

1) First, the cost of the project must be determined. This is similar to finding the price that must be
paid for a stock or bond.
2) Next, management estimates the expected cash flows from the project, including the salvage value
of the asset at the end of its expected life. This is similar to estimating the future dividend or interest
payment stream on a stock or bond, along with the stock's expected sales price or the bond's
maturity value.
3) Third, the risk of the projected cash flows must be estimated. This requires information about the
probability distribution (risk) of the cash flows.
4) Given the project's risk, Management determines the cost of capital at which the cash flows should
be discounted.
5) Next, the expected cash flows are put on a present value basis to obtain an estimate of the asset's
value. This is equivalent to finding the present value of a stock’s expected future dividends.
6) Finally, the present value of the expected cash flows is compared with the required outlay. If the PV
of the cash flows exceeds the cost, the project should be accepted. Otherwise, it should be rejected.
(Alternatively, if the expected rate of return on the project exceeds its cost of capital, the project is
accepted.)

Q. List the six steps in the capital budgeting process, and compare them with the steps in security
valuation.