2.21 The Capital Budgeting Process Summary and Review 

The corporation will/should go through the following steps prior to making a capital allocation decision.

  • Identify and collect the relevant data from the field. Include expected changes in every affected functional area of the business.
  • Use Free Cash Flow numbers.
  • Do not use accounting-type data. Rules are made by people; rules are arbitrary. It is cash that creates value.
  • Use incremental numbers only. It is these data upon which we base our decisions.
  • Organize your data assiduously. Decide on how many future periods you will project out. Figuring projected EBITDA and Free Cash Flow is not so simple.
  • Account for any operating efficiencies or economies of scale that are generated by the investment.
  • Expected inflation should be built into the projected cash flow data. The projected data will be discounted using the (weighted average-) cost of capital.
  • Financing flows are ignored in arriving at Free Cash Flow; they are part of the discount rate (weighted average-) cost of capital.
  • Choose the correct cost of capital. It changes periodically. We observed that small differences in discount rate can matter.
  • Consider the competition. What will happen competitively if the firm rejects the project?
  • What capital budgeting technique will you choose?
  • Are you brave (or foolish?) enough to go against the capital budgeting decision rules based on, potentially subjective, qualitative notions?
  • Some companies may choose not to make certain investments for ethical reasons – even though the project may be hugely profitable. These companies will refuse to pollute, for example. “ESG” or Environmental and Social Governance considerations are important today to many corporations.


Icon for the Creative Commons Attribution 4.0 International License

Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

Share This Book