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complete with its real options is greater than the cost of initiating the project, then the project should
be given the go-ahead.
Summary and Conclusions
Capital budgeting is the process by which a firm chooses which projects to adopt and which to reject.
It is an extremely important endeavor, because it ultimately shapes the firm and the economy as a
whole. The fundamental principle underlying capital budgeting is that a firm should adopt the projects
that create the most wealth. Net present value (NPV) measures how much wealth a project creates.
NPV is computed by forecasting a project‟s cash flows, discounting those cash flows at the project‟s
weighted average cost of capital (WACC), and then summing the discounted cash flows. The cost of
capital used to discount the cash flows is a function of the riskiness of the project and the financing
mix selected.
Measures such as payback period, discounted payback period, and internal rate of return (IRR) give
rise to alternative project decision rules. These rules, however, are flawed and can potentially lead a
company to adopt an inferior project or reject the optimal one. Economic value added (EVA) is a
metric that helps managers choose among projects and then manage the projects once started. The real
options paradigm is an innovation that aims to capture the value of strategic flexibility created by
projects.
The tools of capital budgeting can be applied to large-scale corporate decisions, such as whether to
build a new plant, but they can also be applied to smaller personal decisions, such as which home
mortgage program to choose or whether to invest in new office equipment. Learning the language and
tools of capital budgeting can help entrepreneurs better pitch their projects to investors or to the top
executives at their own firms. Whether the decision is large or small, the fundamental principle is the
same: A good project is one that is ultimately worth more than it costs to set up and thereby generates
wealth.
Note
1 This is one definition of ROA; another definition is net earnings divided by total assets. Given the
second definition, ROA would be affected by leverage.
For Further Reading
Amram, Martha, and Nalin Kulatilaka, Real Options: Managing Strategic Investment in an Uncertain
World (Boston: Harvard Business School Press, 2000).
Bodie, Zvi, and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice Hall, 2000).