312 Planning and Forecasting
trademark. The second new paradigm we will brief ly examine is known as “real
options.”
Economic Value Added
Economic value added (EVA™) is an accounting metric that aims to capture
how much wealth a company creates in a given year. EVA is the amount of in-
vested capital multiplied by the spread between the company’s return on in-
vested capital and its cost of capital. EVA aims to measure wealth creation in a
given year rather than over the life of a project. EVA’s advocates advise man-
agers to adopt projects that maximize EVA and manage projects so as to maxi-
mize EVA each year. Managers should monitor projects and make modifications,
award incentives, and impose penalties to continuously boost EVA.
Real Options
The real options paradigm seeks to measure not only the value of a project’s
forecasted cash f lows but also the value ofstrategic f lexibility that a project
creates for a company. For example, suppose a company is contemplating an ini-
tiative to market its wares on the Internet. The forecast cash f lows may be
weak, but establishing a presence on the Internet may be valuable in that it
wards off potential competition and creates opportunities that can later be ex-
ploited. The option to expand or the f lexibility to later pursue a wide range of
initiatives is captured using the real option paradigm, whereas the value of
these options is usually missed completely in the standard NPV approach. The
real options paradigm entails identifying the strategic options inherent in a pro-
posed project and then valuing them using modern mathematical option-
pricing formulas. If the value of a proposed project complete with its real
options is greater than the cost of initiating the project, then the project should
be given the go-ahead.
SUMMARY AND CONCLUSIONS
Capital budgeting is the process by which a firm chooses which projects to
adopt and which to reject. It is an extremely important endeavor because it ul-
timately shapes the firm and the economy as a whole. The fundamental princi-
pal underlying capital budgeting is that a firm should adopt the projects that
create the most wealth. Net present value (NPV) measures how much wealth a
project creates. NPV is computed by forecasting a project’s cash f lows, dis-
counting those cash f lows at the project’s weighted average cost of capital
(WACC), and then summing the discounted cash f lows. The cost of capital
used to discount the cash f lows is a function of the riskiness of the project and
the financing mix selected.