632598256894

A beer company is considering building a new brewery. An airline is deciding whether to add flights
to its schedule. An engineer at a high-tech company has designed a new microchip and hopes to
encourage the company to manufacture and sell it. A small college contemplates buying a new
photocopy machine. A nonprofit museum is toying with the idea of installing an education center for
children. Newlyweds dream of buying a house. A retailer considers building a Web site and selling on
the Internet.
What do these projects have in common? All of them entail a commitment of capital and
managerial effort that may or may not be justified by later performance. A common set of tools can be
applied to assess these seemingly very different propositions. The financial analysis used to assess
such projects is known as “capital budgeting.” How should a limited supply of capital and managerial
talent be allocated among an unlimited number of possible projects and corporate initiatives?
The Objective: Maximize Wealth
Capital budgeting decisions cut to the heart of the most fundamental questions in business. What is the
purpose of the firm? Is it to create wealth for investors? To serve the needs of customers? To provide
jobs for employees? To better the community? These questions are fodder for endless debate.
Ultimately, however, project decisions have to be made, and so we must adopt a decision rule. The
perspective of financial analysis is that capital investment belongs to the investors. The goal of the
firm is to maximize investors‟ wealth. Other factors are important and should be considered, but this is
the primary objective. In the case of nonprofit organizations, wealth and return on investment need not
be measured in dollars and cents but rather can be measured in terms of benefits to society. But in the
case of for-profit companies, wealth is monetary.
A project creates wealth if it generates cash flows over time that are worth more in present value
terms than the initial setup cost. For example, suppose a brewery costs $10 million to build, but once
built it generates a stream of cash flows that is worth $11 million. Building the brewery would create
$1 million of new wealth. If there were no other proposed projects that would create more wealth than
this, then the beer company would be well advised to build the new brewery.
This example illustrates the net present value (NPV) rule. Net present value is the difference
between the setup cost of a project and the value of the project once it is set up. If that difference is
positive, then the NPV is positive and the project creates wealth. If a firm must choose from several
proposed projects, the one with the highest NPV will create the most wealth, so it should be the one
adopted. For example, suppose the beer company can either build the new brewery or, alternatively,
introduce a new product—a light beer, for example. There is not enough managerial talent to oversee
more than one new project, or maybe there are not enough funds to start both. Let us assume that both
projects create wealth: The NPV of the new brewery is $1 million, and the NPV of the new-product
project is $500,000. If it could, the beer company should undertake both projects; but since it has to
choose, building the new brewery would be the right option because it has the higher NPV.
Computing NPV: Projecting Cash Flows