The Optimal Capital Budget

Optimal Capital Budget- the annual investment in long term assets that maximizes the firm’s value.

Capital Rationing- the situation in which a firm can raise only a specified, limited amount of capital
regardless of how many good projects it has.

For planning purposes, managers must forecast the total capital budget, because the amount of capital
raised affects the WACC and thus influences projects’ NPVs.

Step 1. The treasurer obtains an estimate of the firm’s overall composite WACC.

Step 2. The corporate WACC is scaled up or down for each of the firm’s divisions to reflect the division’s
capital structure and risk characteristics.

Step 3. Financial managers within each of the firm’s divisions estimate the relevant cash flows and risks
of each of their potential projects.

Step 4. Each project’s NPV is then determined, using its risk-adjusted cost of capital.

The procedures discussed in this section cannot be implemented with much precision. However, they do
force the firm to think carefully about each division’s relative risk, about the risk of each project within
the divisions, and about the relationship between the total amount of capital raised and the cost of that
capital.