Time Value of Money About This Section Capital investment decisions are among the most important that management can make. Often capital is a company's scar- cest resource, and using capital wisely is essential for success. Capital investments are long-term bets to build a better future. More than any other business action, capi- tal investment decisions will dene the company and its ultimate value. Faced with limited capital resources, management must carefully decide which capital projects are economically feasible. Management must select projects that will contribute the most to increasing the com- pany's value. This process of evaluating, comparing and selecting projects is called "capital budgeting." Budget, from the French bougette, or purse, refers to a list of all planned expenses and revenues. It is a plan for saving and spending. Capital budgeting is a systematic ap- proach to determining whether a com- pany's planned major capital investments are worth pursuing. Capital budgeting is concerned with the justication of capital expenditures. Capital budgeting analysis can provide a rationale to select between alternative projects by answering the question "Which proposed project will most increase the company's value over time?" This section will introduce you to the quantitative tools necessary to make good capital investment decisions. Then in the last chapter, Chapter 22, we will apply all this new knowledge evaluating our own expansion plans and capital budgeting for AppleSeed Enterprises. Long-term projects usually spend cash (i.e., negative cash ow) early in the project's lifetime and harvest rewards (i.e., positive cash ow) later. Different projects can have very different cash ows both in dol- lar amounts and in timing. To compare project values, we will use numeric tech- niques that take into account the "time value of money." First, the analysis requires estimating the size and timing of all incremental cash ows from the project. These future cash ows are then "discounted" to estimate their present value (PV). These present values (both investments and returns) are then summed to get the so-called net pre- sent value (NPV) of the project in today's dollars. NPV is the estimated value added to the company by executing the project. Generally, the project with the highest NPV is selected to go forward. A discount rate is used in NPV calcu- lations. This rate is similar to an interest rate, but in reverse. A commonly used dis- count rate for capital budgeting is the company's weighted average cost of capital (WACC), which takes into account the company's nancing mix. An additional rate increment is added if the project car- ries a higher risk than that of the company as a whole. This discount rate is some- times called the "hurdle rate," the com- pany's minimum acceptable return. But Beware! Having a quantitative basis for evaluating business decisions can pro- vide objectivity. However, the rigid methodologies used can force poten- tially flawed assumptions and projec- tions that will compromise the analy- sis. Just because resultant numbers look precise and accurate does not mean they are meaningful. Don't forget the maxim "garbage in; garbage out." -- 239 --