Capital budgeting decisions are central to the company’s success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion.
The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May 1994. Instead of providing profits on the investment, accumulated losses on the park by that date were more than $200 million.
Contrast that with Boeing’s decision to “bet the company” by developing the 757 and 767 jets. Boeing’s investment in these planes was $3 billion, more than double the total value of stockholders’ investment as shown in the company’s accounts at the time.
By 1997, estimated cumulative profits from this investment were approaching $8 billion, and the planes were still selling well.
Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value.
Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeing’s investment produced a stream of cash flows that were worth much more than its $3 billion outlay.
Not all investments are in physical plant and equipment. For example, Gillette spent around $300 million to market its new Mach3 razor. This represents an investment in a nontangible asset—brand recognition and acceptance. Moreover, traditional manufacturing firms are not the only ones that make important capital budgeting decisions.
For example, Intel’s research and development expenditures in 1998 were more than $2.5 billion.4 This investment in future products and product improvement will be crucial to the company’s ability to retain its existing customers and attract new ones.
Today’s investments provide benefits in the future. Thus the financial manager is concerned not solely with the size of the benefits but also with how long the firm must wait for them. The sooner the profits come in, the better.
In addition, these benefits are rarely certain; a new project may be a great success but then again it could be a dismal failure. The financial manager needs a way to place a value on these uncertain future benefits.
We will spend considerable time in later material on project evaluation. While no one can guarantee that you will avoid disasters like Euro Disney or that you will be blessed with successes like the 757 and 767, a disciplined, analytical approach to project proposals will weight the odds in your favor.
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