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Reading 35  Capital Budgeting Introduction
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Capital budgeting is the process that companies use for decision making on capital projects—those projects with a life of a year or more. This is a fundamental area of knowledge for financial analysts for many reasons.

  • First, capital budgeting is very important for corporations. Capital projects, which make up the long-term asset portion of the balance sheet, can be so large that sound capital budgeting decisions ultimately decide the future of many corporations. Capital decisions cannot be reversed at a low cost, so mistakes are very costly. Indeed, the real capital investments of a company describe a company better than its working capital or capital structures, which are intangible and tend to be similar for many corporations.

  • Second, the principles of capital budgeting have been adapted for many other corporate decisions, such as investments in working capital, leasing, mergers and acquisitions, and bond refunding.

  • Third, the valuation principles used in capital budgeting are similar to the valuation principles used in security analysis and portfolio management. Many of the methods used by security analysts and portfolio managers are based on capital budgeting methods. Conversely, there have been innovations in security analysis and portfolio management that have also been adapted to capital budgeting.

  • Finally, although analysts have a vantage point outside the company, their interest in valuation coincides with the capital budgeting focus of maximizing shareholder value. Because capital budgeting information is not ordinarily available outside the company, the analyst may attempt to estimate the process, within reason, at least for companies that are not too complex. Further, analysts may be able to appraise the quality of the company’s capital budgeting process—for example, on the basis of whether the company has an accounting focus or an economic focus.

This reading is organized as follows: Section 2 presents the steps in a typical capital budgeting process. After introducing the basic principles of capital budgeting in Section 3, in Section 4 we discuss the criteria by which a decision to invest in a project may be made.

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