Capital Budgeting and the Financing Decision: An Exposition

Abstract

* A gap in the literature on the relationship between capital structure and capital budgeting currently confronts students of financial management. In the standard textbooks (Van Horne [11] and Weston and Brigham [13], for example), capital budgeting is usually taken up early, in the context of all-equity financing. The capital structure decision is treated later, under the general rubric of firm valuation, and it is noted that capital structure can react back on the capital budgeting decision through variation in the weighted average cost of capital. While this separate treatment avoids undue complication early in the student's exposure to basic financial concepts, it sometimes results in a lingering confusion. A number of different cost of capital measures are usually introduced in the discussion of capital structure and firm valuation, and how or whether all of these measures may be used in capital budgeting is not always clear. If the student then turns to the more advanced literature, he becomes entangled in a continuing controversy over the proper use and measurement of the cost of capital (Ang [1], Beranek [2], Lewellen [4], Myers [8] and Nantell and Carlson [9], to name only a few). This article attempts to better integrate analysis of the capital structure and capital budgeting decisions on a relatively straightforward level. The capital budgeting decision is viewed as a valuation problem, and three capital budgeting procedures (the net present value, adjusted present value and flows-to-equity methods) are seen to correspond to different ways of approaching firm valuation. The analysis in this article rests on a number of simplifying assumptions under which all of the valuation methods and capital budgeting procedures are equivalent. The objective is to highlight the relationships among different cost of capital measures and equip the interested reader to pursue controversial points in the more advanced literature.