Introduction to Finance

Capital budgeting
is the process of identifying, evaluating, and implementing a fi rm’s 
investment opportunities. Capital budgeting seeks to identify projects that will enhance a 
fi rm’s competitive advantage and, by so doing, will increase shareholders’ wealth. By its 
nature, capital budgeting involves long-term projects, although capital budgeting techniques 
can be applied to working capital decisions.
1
Capital budgeting projects usually require large 
initial investments and may involve acquiring or constructing plant and equipment. A pro-
ject’s expected time frame may be as short as a year or as long as 20 or 30 years. Projects may 
include implementing new production technologies, products, markets, or mergers. Given 
their size and duration, the projects undertaken by the fi rm should refl ect its overall strategy 
for meeting future goals. Given the length of most projects, time value of money concepts 
should be used to evaluate them.
capital budgeting 
process of 
identifying, evaluating, and 
implementing a fi rm’s investment 
opportunities
1
See Terry S. Maness and John T. Zietlow, 
Short-Term Financial Management
, (Mason, OH: Thomson South-Western, 
2005); Ned C. Hill and William Sartoris, 
Short-Term Financial Management
, 3rd ed., (Englewood Cliff s, N.J.: 
Prentice-Hall, 1995).

---

522
C H A PT E R 1 7 Capital Budgeting Analysis
The typical capital budgeting project involves a large up-front cash outlay, followed by 
a series of smaller cash infl ows and outfl ows, but the project’s cash fl ows, including the total 
up-front cost of the project, are not known with certainty before the project starts. The fi rm 
must evaluate the size, timing, and risk of the project’s cash fl ows to determine if it enhances 
shareholder wealth. 
The profi tability of a fi rm is aff ected to the greatest extent by its management’s success 
in making capital budget investment decisions. A fi xed-asset decision will be sound only if it 
produces a stream of future cash infl ows that earns the fi rm an acceptable rate of return on its 
invested capital.
Fixed-asset management requires fi nancial managers to compare capital expenditures 
for plant and equipment against the cash fl ow benefi ts received from these investments over 
several years. When properly adjusted benefi ts exceed expenditures, these projects will help 
increase the fi rm’s value.
Investment in assets provides the basis for a fi rm’s earning power or profi tability. Plant, 
equipment, training, and infrastructure are employed to manufacture inventories or provide 
services that will be sold for profi t, produce cash infl ows, and enhance the fi rm’s value. The 
fi nancial manager must make appropriate capital budgeting decisions for these to occur. The 
types of decisions include whether to replace existing equipment with new equipment, expand 
existing product lines by adding more plant and equipment similar to that in use, or expand 
into new product areas requiring new types of assets.
Capital budgeting decisions can involve mutually exclusive or independent projects. As 
an example of