AN INTRODUCTORY COURSE
RISK, RETURN, AND CAPITAL BUDGETING
I. A Review:
We have learned that the field of corporate finance is preoccupied with two major questions:
In which assets should the firm invest? The investment decision. This question concerns the composition of the left-hand side of a firm's balance sheet, the asset side. We use the terms capital budgeting and capital expenditures to describe the process of making and managing expenditures on assets, particularly long-term assets. The working capital management decision, i.e., short-term asset levels, is a subset of the investment decision.
How should the firm raise capital to finance these capital expenditures, or the financing decision? This question addresses the design of the firm's financial structure, or the proportion of debt (both short-term and long-term) versus equity securities on the right-hand side of the firm's balance sheet. The dividend decision is a subset of the financial structure decision since this decision affects how much equity remains in the firm.
Chapter 12 in RWJ provides another step in our search for an answer to the first of these questions. We conclude this search in Chapter 17, where we pull together the discussion of the investment and financial structure decisions. In Chapter 13, we begin addressing the second of these major questions, or the design of the firm's financial structure.
As you also should recall from prior material, we evaluate projects using the Net Present Value Rule, or the NPV Rule. This rule says that you discount a project's after-tax cash flows at the rate r, or
NPV = C0 + Σ Ct/(1 + r)t, where
C0 = the time = 0 after-tax cash flow, usually negative,
Ct = after-tax cash flows from time 1 to time T, either positive or negative,
1 This lecture module is designed to complement Chapter 18 in Ross, Westerfield, and Jaffe.