SPEAKER: Hi. Welcome back to finance for non finance professionals. I'd like to talk right now about an overview of what we call the capital budgeting process, which is how firms spend money. Now when we think about firms, where do they get their money? They get their money from the fact that firms have a set of assets, and they use those assets to try to generate profits. What happens with those profits that the firm brings in? They take that cash flow, or the profits that they make, and the financial manager, or the CFO, or the treasurer, the comptroller, someone in doing the finances of the business, thinks about what to do with the cash flow that's being generated by use of the firm's assets. Well, one thing we could do is just pilot it right back through to the people that own the firm. The capital markets. The bondholders, the debt holders, the equity holders. That cash flow generated by the firm could be paid directly out through dividends or repurchases, to the financial markets, the investors in the company. The other thing the financial manager could do with that cash flow is, rather than give it back to shareholders or bondholders, reinvest it. Buy more stuff. Increase the firm's assets in order to increase future profitability. The other thing the financial manager could try to do is, maybe the assets aren't generating enough cash flow, and so the financial manager decides to pull in extra cash from the financial markets. Issuing bonds, getting another bank note, issuing additional equity. Pulling cash from the capital markets into the firm. You could use that to buy more assets. This sort of diagram that links all these things together, is what we call the capital budgeting process. If we use other people's money, either through debt or through equity, have to pay them for it. As we spend the firm's money, what is it that we pay the investors, who we're asking to be patient? If you think back to our lecture one, when we were talking about compounding and interest rates, we were thinking that people didn't want to be patient, naturally. And so if we were asking people to be patient, we had to pay them something. We had to pay them that return or that interest rate. And that's exactly what we're going to do when we're using the firm's assets to generate money, because all of the bondholders, and stockholders, and banks that are sort of letting the firm borrow money to do its business, have to get paid. So what should we pay them? Implicitly we're going to pay them that r. That discount rate, that compound rate, that interest rate that we talked about all through week one. And so capital budgeting is really the science or the decision making that goes on behind how, when, and where the firm should spend its money in order to maximize the return that it can give to its investors, its bondholders, and its stockholders. You can think about this very similarly to the fact that if a friend or a family member wants to borrow money from you, what are the sort of things that you would ask them? You would ask them, well, when am I going to get my money back? You would ask them, OK, how much risk is involved in whether or not I'm going to get my money back? And, what would I have done with the money? Oh, gosh, I can't lend you the money right now. I need a new car or I need a new refrigerator. The opportunity cost is simply too high. And those are the-- exactly the kinds of things that the firm is going to think about when deciding whether to invest or give that money back to its investors, the timing, the risk, and the opportunity costs. All of that's going to come down to a trade off between risk and return. And that's exactly what we're going to try to measure through our use of capital budgeting tools. We want to come up with a practice for capital budgeting that sort of incorporates a lot of the best policies and practices that we see in large corporations. The two main things that we're going to look for in any capital budgeting measure are first, that it's an arm's length measure. What that means in sort of accounting terms is that there's no inside dealing. It's not me and my cousin deciding how we're going to split up the assets of the firm, but that there's a sort of separation between everyone acting in their own interests. That the interests of the people that are borrowing the money aren't commingled with the interests of the people that are lending the money, an arm's length transaction. The other is that it's objective. The two of us can sit down, both the borrower and the borrowee, can sit down together and say, yeah, OK, these metrics seem to make sense. We could look at the spreadsheet together and agree. And that also goes into being transparent. We could report it to external investors, or the Securities and Exchange Commission, or the accounting standards boards, or any member of the board of directors or investor groups, that want to see our results and look at our metrics and look at our capital budgeting decisions, that they're easy to understand, that they're transparent. So our capital budgeting tool should be arm's length, objective, and transparent. If they meet those three criteria, then it's probably a good tool for deciding how and where to spend money. The kinds of decisions that we're going to make in the capital budgeting process involve whether to accept or reject a project, whether we're going to rank a set of projects, and figure out which one is best, or whether we're going to within a group of projects decide which one, or maybe both, or maybe neither. All of this, what we're going to do is basically comes down to a very basic cost benefit analysis in economics, which sounds obvious, but it's actually kind of tricky to measure once we get into multiple projects and multiple timings of the projects. We're going to need to bring in a little bit more technology in order to figure out what the best practices are. What we're going to do in this week, is review the different tools that we use for capital budgeting. We're going to try to understand the trade offs between using each of those different tools. And we're going to talk about how those metrics are used in perspective of capital markets versus decisions inside the firm. And then we're going to talk about the sensitivity analysis that goes on. If we pull and push on each of these different metrics, to what extent do they give us different answers? And at the end we're going to put all those metrics together and build out some real applications, and some spreadsheet models, and some practical examples of the capital budgeting process.
