CFA Level I - Reading 44

The capital budgeting process is the process of identifying and evaluating projects where the cash flows will be received over a period longer than a year and has four administrative steps:

1. Idea generation.
2. Analyzing project proposals.
3. Create the firm-wide capital budget.
4. Monitoring decisions and conducting a post-audit.

Capital budgeting projects may be divided into the following categories:

• Replacement projects to maintain the business.
• Replacement projects for cost reduction.
• Expansion projects.
• New product or market development.
• Mandatory projects.
• Other projects. 

1. Decisions are based on cash flows, not accounting income. The relevant cash flows to consider are incremental cash flows. Sunk costs should not be included in the analysis. Externalities should be included in the analysis.
2. Cash flows are based on opportunity costs. Opportunity costs should be included in project costs. These are cash flows generated by an asset the firm already owns, that would be forgone if the project under consideration is undertaken.
3. The timing of cash flows is important. Cash flows received earlier are worth more than cash flows to be received later.
4. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing capital budgeting projects.
5. Financing costs are reflected in the project’s required rate of return. Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm. 

• The average accounting rate of return (AAR) is defined as the ratio of a project’s average net income to its average book value.
• The profitability index (PI) is the present value of a project’s future cash flows divided by the initial cash outlay.

• Location: European countries tended to use the payback period method as much or more than the IRR and NPV methods.
• Size of the company: The larger the company, the more likely it was to use discounted cash flow techniques such as the NPV and IRR methods.
• Public vs. private: Private companies used the payback period more often than public companies. Public companies tended to prefer discounted cash flow methods.
• Management education: The higher the level of education, the more likely the company was to use discounted cash flow techniques.

The Relationship Between NPV and Stock Price: In theory, a positive NPV project should cause a proportionate increase in the company’s stock price. In reality, changes in the stock price will result more from changes in expectations about a project’s profitability.