Capital Budgeting

Capital budgeting is the process a business undertakes to evaluate potential

major projects or investments. Construction of a new plant or a big investment
in an outside venture are examples of projects that would require capital
budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project's

lifetime cash inflows and outflows to determine whether the potential returns
that would be generated meet a sufficient target benchmark. The capital
budgeting process is also known as investment appraisal.

Assume, for example, a plumbing company uses a truck and equipment to

complete residential work, and the total cost of these assets is $50,000. The
more sales the plumbing firm can generate using the truck and the equipment,
the more shareholder value the business creates. Valuable companies are
those that can increase earnings with the same dollar amount of assets.

Instances Where Cash Flow Increases Value

Generating sufficient cash inflows to operate the business is also an important

indicator of shareholder value because the company can operate and
increase sales without the need to borrow money or issue more stock. Firms
can increase cash flow by quickly converting inventory and accounts
receivable into cash collections.

The rate of cash collection is measured by turnover ratios, and companies

attempt to increase sales without the need to carry more inventory or increase
the average dollar amount of receivables. A high rate of both inventory
turnover and accounts-receivable turnover increases shareholder value.

Factoring in Earnings per Share

If management makes decisions that increase net income each year, the
company can either pay a larger cash dividend or retain earnings for use in
the business. A company’s earning per share is defined as earnings available
to common shareholders divided by common stock shares outstanding, and
the ratio is a key indicator of a firm’s shareholder value. When a company can
increase earnings, the ratio increases and investors view the company as
more valuable.

KEY TAKEAWAYS

• Shareholder value is the value given to stockholders in a company

based on the firm's ability to sustain and grow profits over time.
• Increasing shareholder value increases the total amount in the
stockholders' equity section of the balance sheet.
 • The maxim about increasing shareholder value is in fact a practical
myth—there is no legal duty for management to maximize corporate
profits.

Understanding Shareholder Value

Increasing shareholder value increases the total amount in the stockholders'
equity section of the balance sheet. The balance sheet formula is: assets,
minus liabilities, equals stockholders' equity, and stockholders' equity includes
retained earnings, or the sum of a company's net income, minus cash
dividends since inception.