Objectives

1. To explain the nature and significance of capital budgeting.

2. To describe and distinguish between different types of investment or capital expenditure.

3. To explain the process and principles of cash flow analysis.

4. To explain the different methods of evaluating investment projects.

5. To explain the concept and measurement of the cost of capital.

6. To explain the nature and significance of risk and uncertainty in investment appraisal.

7. To examine the measurement of risk.

8. To explain the different ways of incorporating risk into managerial decision-making in terms of investment analysis.

9. To explain the concept of the optimal capital budget and how it can be determined.

Introduction

The nature and significance of capital budgeting

So far in the analysis of the previous chapters we have concentrated largely on the aspects of managerial decision-making that relate to making the most efficient use of existing resources. It is true that some aspects of decision-making in the long run have been considered, for example determining the most appropriate scale for producing a given output (Chapter 6), and the decision to expand capacity in a duopolistic market (Chapter 9), but many factors were taken as given in these situations. This chapter examines these long-run decisions in more detail, and explains the various factors that need to be considered in determining whether to replace or expand a firm's resources. As has been the case throughout the book, it will normally be assumed that the firm's objective is to maximize shareholder wealth, but certain aspects of public sector decision-making will also be considered, and these will be examined in further detail in the final chapter.