Making Capital Investment Decisions

In late April 2000, Unilever PLC, the Anglo-Dutch consumer products giant, announced it would make two significant additions to its menu of products at a total cost of $2.6 billion. First, in a bid to be a player in the diet sector, Unilever acquired SlimFast Foods, Inc., the Florida-based maker of diet products, in a deal valued at $2.3 billion. At the time, SlimFast commanded roughly a 45 percent share of the U.S. market for diet and nutrition products. Second, to increase its market share in a decidedly un-diet sector, Unilever acquired Ben & Jerry's Homemade, Inc., the well-known ice cream chain, for $326 million. Both moves were aimed at increasing the firm's presence in the U.S. market.

As you no doubt recognize from your study of the previous chapter, these acquisitions represent capital budgeting decisions. In this chapter, we further investigate capital budgeting decisions, how they are made, and how to look at them objectively.

This chapter follows up on our previous one by delving more deeply into capital budgeting. We have two main tasks. First, recall that in the last chapter, we saw that cash flow estimates are the critical input into a net present value analysis, but we didn't say very much about where these cash flows come from; so we will now examine this question in some detail. Our second goal is to learn how to critically examine NPV estimates, and, in particular, how to evaluate the sensitivity of NPV estimates to assumptions made about the uncertain future.

So far, we've covered various parts of the capital budgeting decision. Our task in this chapter is to start bringing these pieces together. In particular, we will show you how to "spread the numbers" for a proposed investment or project and, based on those numbers, make an initial assessment about whether or not the project should be undertaken.

In the discussion that follows, we focus on the process of setting up a discounted cash flow analysis. From the last chapter, we know that the projected future cash flows are the key element in such an evaluation. Accordingly, we emphasize working with financial and accounting information to come up with these figures.

Ross et al.: Fundamentals I IV. Capital Budgeting I 10. Making Capital I I © The McGraw-Hill of Corporate Finance, Sixth Investment Decisions Companies, 2002

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312 PART FOUR Capital Budgeting

In evaluating a proposed investment, we pay special attention to deciding what information is relevant to the decision at hand and what information is not. As we shall see, it is easy to overlook important pieces of the capital budgeting puzzle.

We will wait until the next chapter to describe in detail how to go about evaluating the results of our discounted cash flow analysis. Also, where needed, we will assume that we know the relevant required return, or discount rate. We continue to defer in-depth discussion of this subject to Part 5.

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