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Security Valuation & Capital Budgeting

In both Security Valuation and Capital Budgeting, attempts are made to predict present value of future returns to assess the value of a project and earnings/dividends to assess the current price of a security. In security valuation (shares), the current share price is based on the expected future value of a share plus any dividends in the intervening years, all brought into the same context by deriving the values at the present time. In security valuation (bonds), the future return has an impact on the current price. In Capital Budgeting, future net cash flows over the life of the project are brought into the same context by deriving the values at the present time, either in absolute or relative terms. In Security Valuation, the analyst can assess which security prices are under/over-valued and act accordingly. In Capital Budgeting, the relative performance of alternative projects are assessed and chosen accordingly.

Therefore, Security Valuation and Capital Budgeting are similar in that they use similar methodologies to differentiate between the relative merits of identified securities, or available projects. In both cases, the aim is to maximise the worth/value to the individual/company over a period of time. For example, if a share is under-valued relative to expected future earnings, purchase now and sale at a later date should deliver an increase in net worth. In Security Valuation, the securities should be chosen to deliver the maximum increase in Net Worth over a fixed time horizon. In Capital Budgeting, the best combination of projects should be chosen to deliver the maximum return on capital invested, over a fixed time horizon.

As denoted above, Capital Budgeting has a direct effect on Security Valuation by prioritising projects that will result in the greatest increase in future earnings/dividends, increasing the likely dividends or interest payable, and increasing the valuation of the price of a share. The choice of projects will have an impact on Cash Flow and when capital is required to fund the investment required. This in turn will also have an impact on future company value, dependant on how the capital for the projects is financed.

As a company grows and acquires additional assets, the company liquidity position changes, and the likelihood of future earnings also increases, which should have a positive impact on share price and security valuation. These additional assets allow the company to select from a wider range of projects from which to maximise future wealth. As discussed above, these are Capital Budgeting decisions.

Security Valuation also impacts on the credit rating of a company, which in turn changes the real return required on projects, and the discount rates which should be applied to the Net Present Value calculations within Capital Budgeting. For example, if too much Commercial Paper is issued by a company, this will increase its gearing and financial risk, and will cause a Credit Rating Downgrade.

Therefore, Security Valuation and Capital Budgeting have similar methodologies and are closely related.