Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

11- 4 STRATEGY AND CAPITAL

BUDGETING

Finance textbooks tend to focus on the mechanics of project evaluation: how to estimate cash flows,

how to select the right discount rate, how to calculate an NPV or IRR, and so on. This emphasis on

technique is intentional. Knowing how to apply quantitative discipline to the project selection process

is crucial. Nevertheless, experienced managers rarely make major investment decisions based solely on

NPV calculations. The best managers have a well-honed intuition that tells them why a particular project

would or would not be a good investment. Their business acumen helps them to recognise projects that

will create shareholder value, even if the NPV numbers from financial analysts are negative, and to avoid

investments that will destroy value, even when the NPV calculations are positive.

11- 4a COMPETITION AND NPV

Sadly, no textbook can adequately substitute for the invaluable experience of making many investment

decisions over several years and then watching some of them succeed and others fail. However, there are

certain common characteristics shared by projects that enhance shareholder value.

Recall some of the most basic lessons from microeconomics about a perfectly competitive market.

In such a market, there are many buyers and sellers trading a similar product or service. Because every

player in the market is small relative to the whole market, everyone behaves as if his or her decisions

and actions will not affect prices. Competition and the lack of entry or exit barriers ensures that in the

long run, the product’s market price equals the marginal cost of producing it, and no company earns pure

economic profit.^7 In a market with zero economic profits, the NPV of any investment equals zero: every

project earns just enough to recover the cost of capital, no more and no less.

Therefore, how can any project earn a positive NPV? The answer: A project can earn a positive NPV

only when markets are not perfectly competitive. For example, if the project calls for production of a new

good, is there something about this good that clearly differentiates it from similar goods already in the

market? If the new product is genuinely unique, is there some kind of entry barrier (such as patents or

limited access to production inputs) that will prevent other companies from producing their own, nearly

identical versions of the product, competition that would eventually preclude any pure economic profits?

Competitive advantages of this sort can come in many forms. One company may have superior

engineering or R & D talent that generates a continuous stream of innovative products. Another may

excel at low-cost manufacturing processes. Still another may create a sustainable competitive advantage

through its unique marketing programs. The main point is that if any project is to have a positive NPV, then

advocates of that project should be able to articulate its lasting competitive advantage even before running the

numbers. No matter how positive the project’s NPV appears to be on paper, if no one can explain its main

competitive advantage in the market, then the company should probably think twice about investing.

Similarly, when an investment proposal has a compelling reason for its competitive edge, but the NPV

numbers come out negative, it may be worth sending the financial analysts back to their desks to take a

second look at their assumptions.

7 Remember that the notion of ‘economic profit’ differs from ‘accounting profit’. If a company makes a zero economic profit, then it earns just

enough to pay competitive prices for the labour and capital that it employs to produce a good or service. Zero economic profit is equivalent to

an NPV of zero.

How can a project earn a

positive NPV in the long run?

Why doesn’t competition drive

all projects to NPV = $0?

thinking cap
question

Jon Olson, Chief Financial

Officer, Xilinx Corp.

‘Our job at the company

is to test the limits,

not just create financial

analysis that ratifies

peoples’ intuition.’

See the entire interview on

the CourseMate website.

COURSEMATE

SMART VIDEO

Source: Cengage Learning

LO11.6