Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

1 Merger of equals deals are discussed in Chapter 21, section 21-4a.

York Stock Exchange (NYSE) and the Toronto

Stock Exchange) in February 2014, after protracted

negotiations that had commenced as an attempted

merger of equals deal in December 2012.^1

Sources: Adapted from, PMI Gold Corporation news release January 2012;

QuoteMedia, http://tmx.quotemedia.com/pricehistory.php?

qm_page=64353&qm_symbol=PMV; ASX Limited, http://www.asx.com.au/

asx/research/companyInfo. do?by=asxCode&asxCode=PVM; and Bloomberg,

http://www.bloomberg.com/quote/PN3N:GR. Accessed 9 December 2015.

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

understand capital budgeting procedures

and the ideal characteristics of a capital

budgeting technique

evaluate the use of the payback period,

the discounted payback and the

accounting rate of return to evaluate

capital expenditures

discuss the logic, calculation and pros

and cons of the net present value (NPV)

method, as well as a variant of this, the

economic value added (EVA) method

describe the logic, calculation, advantages

and problems associated with the internal

rate of return (IRR) technique

differentiate between the NPV and IRR

techniques by focusing on the scale

and timing problems associated with

mutually exclusive capital budgeting

projects

discuss the profitability index and findings

with regard to the actual use of NPV and

IRR in business practice.

LO9.1

LO9.2

LO9.3

LO9.4

LO9.5

LO9.6

Many decisions that managers make have a long-

term impact on the company, and can be very

difficult to unwind once initiated. Major investments

in plant and equipment fit this description, as does

spending on advertising designed to build brand

awareness and loyalty among consumers. The terms

capital investment and capital spending refer to

investments in these kinds of long-lived assets, and

capital budgeting refers to the process of determining

which of these investment projects a company

should undertake.

The capital budgeting process involves these

basic steps:

1 Identify potential investments.

2 Estimate the incremental inflows and outflows of

cash associated with each investment.

3 Estimate a fair rate of return on each investment

given its risk.

4 Analyse and prioritise the investments utilising

various decision criteria.

5 Implement and monitor the performance of

accepted projects.

Rarely is there a shortage of ideas for how a

company should invest its capital. Compelling

proposals to modernise production equipment,

expand research and development programs,

upgrade information technology or launch

new advertising campaigns pour in from all of

the company’s functional areas. The financial

analyst’s job is to analyse these investment

opportunities, weighing their risks and returns to

determine which projects create the most value

for shareholders.

In this chapter, we describe the different

decision criteria that companies use to make capital

investment decisions, highlighting the strengths

and weaknesses of alternative methods. In the end,

the preferred technique for evaluating most capital

investments is called net present value (NPV).

capital budgeting

The process of determining

which long-lived investment

projects a company should

undertake