9: Capital Budgeting Process and Decision Criteria■ The decision rule to invest when NPVs are positive and to refrain from investing when NPVs are
negative reflects the company’s need to compete for funds in the marketplace and have its projects
outperform projects of similar risk.■ The NPV approach offers a relatively straightforward way to control for differences in risk
among alternative investments. Cash flows on riskier investments should be discounted at
higher rates.■ The NPV method incorporates all the cash flows that a project generates over its life, not just those
that occur in the project’s early years.
■ The NPV gives a direct estimate of the change in shareholder wealth resulting from a given investment.
We are enthusiastic supporters of the NPV approach, especially when compared with the other
decision methods examined thus far. However, there is one subtle drawback to the NPV rule, and it
results from our inability to incorporate the value of managerial flexibility when calculating a project’s
NPV. What we mean by managerial flexibility are options that managers can exploit to increase
the value of an investment. For example, if a company makes an investment that turns out better
than expected, managers have the option to expand that investment, making it even more valuable.
Conversely, if a company invests in a project that does not generate as much positive cash flow as
anticipated, then managers have the option to scale back the investment and re-deploy resources
to more productive uses. The NPV method (like the other methods studied in this chapter) does
a poor job of capturing the value of managerial flexibility. Incorporating the value of these options
into the analysis requires a highly sophisticated approach that relies on the use of decision trees and
the principles of option pricing. We offer a brief introduction to valuing investment with option-like
characteristics in Chapter 11.
The NPV method enjoys widespread use in large corporations, but there are two other popular
capital budgeting tools that are closely related to NPV. One of these alternative approaches,
called economic value added, essentially calculates an investment’s NPV on a year-by-year basis.
The other approach, known as the internal rate of return (IRR), summarises the economic merits
of an investment in a single number, which represents the compound annual rate of return that
an investment earns over its life. In most cases (but not all) these techniques lead to the same
investments decision that NPV analysis does, although there are some important, subtle differences
between the three approaches.
9-4c ECONOMIC VALUE ADDED
Net present value analysis is appealing for making capital budgeting decisions because it is both
theoretically sound and easy to implement. In recent years, a variant of NPV analysis called economic
value added (EVA), or, more generically, shareholder value added (SVA), has become popular with many
companies. A registered trademark of Stern Stewart & Co., EVA is based on the century-old idea of
economic profit. In accounting, we say that a company earns a profit if its revenues are greater than its
costs. But when economists use the term economic profit they refer to how much profit a company earns
relative to a competitive rate of return. If a company earns zero economic profit, then its accounting
profits are positive and just sufficient to satisfy the returns required by the company’s investors. If a
company’s economic profits are positive, then its share price will rise because it is out-earning its cost of
capital and investor expectations. Similarly, a company may be earning a positive accounting profit, but if
that profit does not cover the company’s cost of capital, then economic profits are negative.
economic profit
A profit that exceeds a normal,
competitive rate of return in an
industry or line of business