338 Part 4 Investing in Long-Term Assets: Capital Budgeting
pro! table plants. More detailed analyses are required for cost-reduction projects,
for expansion of existing product lines, and especially for investments in new
products or areas. Also, within each category, projects are grouped by their dollar
costs: Larger investments require increasingly detailed analysis and approval at
higher levels. Thus, a plant manager might be authorized to approve maintenance
expenditures up to $10,000 using a relatively unsophisticated analysis, but the full
board of directors might have to approve decisions that involve amounts greater
than $1 million or expansions into new products or markets.
If a! rm has capable and imaginative executives and employees and if its in-
centive system is working properly, many ideas for capital investment will be ad-
vanced. Some ideas will be good ones, but others will not. Therefore, procedures
must be established for screening projects. Companies use, and we discuss, the
following criteria for deciding to accept or reject projects:^2- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Modi! ed Internal Rate of Return (MIRR)
- Regular Payback
- Discounted Payback
The NPV is the best method, primarily because it addresses directly the central
goal of! nancial management—maximizing shareholder wealth. However, all of
the methods provide useful information, and all are used in practice at least to
some extent.11-2 NET PRESENT VALUE !NPV"
The net present value (NPV) tells us how much a project contributes to share-
holder wealth—the larger the NPV, the more value the project adds; and added
value means a higher stock price.^3 Thus, NPV is the best selection criterion. We use
the data for Projects S and L shown in Table 11-1 to illustrate the calculation. The S
stands for Short; the L, for Long. Project S is a short-term project in the sense that its
cash in" ows come in relatively soon, while L has more total cash in" ows but they
come in later in its life. The projects are equally risky, and they both have a 10%Net Present Value
(NPV)
A method of ranking
investment proposals
using the NPV, which is
equal to the present value
of future net cash flows,
discounted at the cost of
capital.Net Present Value
(NPV)
A method of ranking
investment proposals
using the NPV, which is
equal to the present value
of future net cash flows,
discounted at the cost of
capital.SELF^ TEST How is capital budgeting similar to security valuation? How is it di! erent?
What are some ways that " rms generate ideas for capital projects?
Identify the major project classi" cation categories and explain how and why
they are used.
What is the single best capital budgeting decision criterion?(^2) Two other rarely used criteria, the Pro! tability Index and the Accounting Rate of Return, are covered in
Chapter 12 and its Web Extension of Eugene F. Brigham and Phillip R. Daves, Intermediate Financial Management,
9th ed. (Mason, OH: Thomson/South-Western, 2007).
(^3) We could divide the NPV by the number of shares outstanding to estimate a project’s e" ect on the stock price.
However, given the lag between project acceptance and visible e" ects on earnings, this is rarely done for routine
projects. However, for major projects, this procedure is useful.