Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

9 -1 INTRODUCTION TO CAPITAL

BUDGETING

This section provides an understanding of capital budgeting procedures and the ideal characteristics

of a capital budgeting technique. We start by assessing the traits of ideal investment criteria, and then

introduce a capital budgeting problem that we can use to apply different decision-making techniques.

9 -1a TRAITS OF IDEAL INVESTMENT CRITERIA

Companies use a variety of techniques to evaluate capital investments. Some techniques involve very

simple calculations and are intuitively easy to grasp. Financial managers prefer: (1) an easily applied

technique that (2) considers cash flow; (3) recognises the time value of money; (4) fully accounts for

expected risk and return; and (5) when applied, leads to higher firm value for any company (and higher

share prices in public companies). Easy application accounts for the popularity of some simple capital

budgeting methods such as the payback period and accounting rate of return (both defined later).

Unfortunately, when comparing simple capital budgeting methods with more complex ones, other

things are decidedly not equal. More complex methods, such as net present value (NPV), internal rate of

return (IRR) or the profitability index (PI), generally lead to better decision-making, because they take into

account issues 1–5 cited above, factors that are neglected or ignored by simpler methods. Moreover, we

will learn that the NPV approach provides a direct estimate of the change in share value resulting from a

particular investment. Managers who seek to maximise share value must understand not only how to use

LO9.1

finance in practice

CFO SURVEY EVIDENCE (I)

Table 9.1 lists several of the capital budgeting

methods covered in this chapter and indicates

how widely they are used, according to a survey

of US CFOs. We argue in this chapter that the net

present value (NPV) and internal rate of return

(IRR) are theoretically preferable to methods such

as payback, discounted payback or accounting

rate of return. Apparently, CFOs agree, because

most of them say that the IRR and NPV methods

are their preferred tools for evaluating investment

opportunities. The payback approach is also widely

used. It is interesting that the popularity of NPV

and IRR is particularly high among large companies

and companies with CFOs who have MBA training,

whereas the payback approach sees wider use

in smaller companies. The payback approach, as

the name suggests, focuses on how quickly an

investment produces sufficient cash flow to recover

its up-front costs. Smaller companies probably have

less access to capital than large companies, which

may explain why smaller companies rely so heavily

on the payback method.

TABLE 9.1 POPULARITY OF CAPITAL

BUDGETING TECHNIQUES

Technique Percentage of CFOs

routinely using techniquea

Internal rate of return 76%

Net present value 75%

Payback 57%

Discounted payback 29%

Accounting rate of return 20%

Profitability index 12%

a Note that these rounded percentages are drawn from the

responses of a large number of CFOs and that many respondents

use more than one technique.

Source: Reprinted from J.R. Graham and C.R. Harvey, ‘The Theory and Practice

of Corporate Finance: Evidence from the Field,’ Journal of Financial Economics,

60, pp. 187–243, Copyright 2001, with permission from Elsevier.