Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

project under consideration. When the NPV equals zero, the investment provides a rate of return equal

to shareholders’ required return; all investors should be satisfied by a project with a zero NPV, but no

extra ‘economic profit’ is earned. Therefore, a project with a positive NPV earns a return that exceeds

shareholders’ expectations.

A company that consistently finds positive NPV investments expects to surpass shareholders’

requirements and enjoy a rising share price. Clearly, the acceptance of positive NPV projects is

consistent with the company’s value-creation goal. Conversely, if the company makes an investment

with a negative NPV, the investment will reduce value and shareholder wealth. A company that

regularly makes negative NPV investments will see its share price lag as it generates lower-than-

required returns for shareholders.

Drawing on what we already know about valuing bonds, we can develop an analogy to drive home the

point about the relationship between share prices and the NPV rule. Suppose that, at a given moment

in time, investors require a 5% return on five-year Treasury bonds. Of course, this means that if the

Commonwealth Government issues five-year, $1,000 par value bonds paying an annual coupon of $50,

the market price of these bonds will be $1,000, equal to par value.^3

$1,000=+++

$50

1.05

$50

1.05

...

$1,050

(^12) 1.05 5
Now apply NPV logic. If an investor purchases one of these bonds for $1,000, the NPV equals zero,
because the bond’s cash flows precisely satisfy the investor’s expectation of a 5% return:
NPV==$0 −=$1,000 +++
$50
1.05
$50
1.05
L
$1,050
(^12) 1.05 5
Next, imagine that, in a fit of election-year largesse, the Commonwealth Government decrees that
the coupon payments on all government bonds will double, so this bond now pays $100 in interest per
year. If the bond’s price remains fixed at $1,000, this investment’s NPV will suddenly switch from zero
to positive. At a price of $1,000, the bond is underpriced if the Commonwealth Government raises the
bond’s coupon to $100:
NPV==$216.47 −=$1,000 +++
$100
1.05
$100
1.05
...
$1,100
1.05
12 5
Of course, the bond’s price will not remain at $1,000. Investors will quickly recognise that – with
a price of $1,000 and a coupon of $100 – the return offered by these bonds substantially exceeds
the required rate of 5%. Investors will flock to buy the bonds, rapidly driving up bond values until
prices reach the point at which buying bonds becomes a zero NPV investment once again.^4 In the new
equilibrium, the bond’s price will rise by $216.47, exactly the amount of the NPV that was created when
the Commonwealth Government doubled the coupon payments:
NPV==$0 −=$216.47 −=$1,000 +++
$100
1.05
$100
1.05
....
$1,100
1.05
12 5
3 Though Treasury bonds pay interest semi-annually, here we assume annual interest payments to keep the example simple.
4 Recall that in Chapter 7, we said that an underpriced stock would lie above the security market line. The same thing is happening here. At a
price of $1,000, the bond is under-priced if the Commonwealth Government raises the bond’s coupon to $100. Recognising the under-pricing,
investors will buy the bonds, causing their price to rise and the expected return to fall.