Planning Capital Expenditure 313Measures such as payback period, discounted payback period, and inter-
nal rate of return (IRR) give rise to alternative project decision rules. These
rules, however, are f lawed and can potentially lead a company to adopt an infe-
rior project or reject an optimal one. Economic value added is a new tool re-
cently introduced to help managers choose among projects and then manage
the projects once started. The real options paradigm is another recent innova-
tion that aims to capture the value ofstrategic f lexibility created by projects.
The tools of capital budgeting can be applied to large-scale corporate deci-
sions, such as whether or not to build a new plant, but they can also be applied
to smaller personal decisions, such as which home mortgage program to choose
or whether to invest in new office equipment. Learning the language and tools
of capital budgeting can help entrepreneurs better pitch their projects to in-
vestors or to the top executives at their own firms. Whether the decision is
large or small, the fundamental principle is the same: A good project is ulti-
mately worth more than it costs to set up and thereby generates wealth.
FOR FURTHER READING
Amram, Martha, and Nalin Kulatilaka, Real Options: Managing Strategic Investment
in an Uncer tain World(Boston: Harvard Business School Press, 1999).
Bodie, Zvi, and Robert C. Merton, Finance(Upper Saddle River, NJ: Prentice-Hall,
2000).
Brealey, Richard A., and Stewart C. Myers, Principles of Corporate Finance(New
York: Ir win/McGraw-Hill, 2000).
Brigham, Eugene F., Michael C. Ehrhardt, and Louis C. Gapenski, Financial Man-
agement: Theory and Practice(New York: Dryden Press, 1999).
Dixit, Avinash K., and Robert S. Pindyck, “The Options Approach to Capital Invest-
ment,” Harvard Business Review, 73(3) (May/June 1995): 105–115.
Emery, Douglas R., and John D. Finnerty, Corporate Financial Management(Upper
Saddle River, NJ: Prentice-Hall, 1997).
Higgins, Robert C., Analysis for Financial Management(New York: Ir win/McGraw-
Hill, 2001).
Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe, Corporate Finance
(New York: Ir win/McGraw-Hill, 1999).
Trigeorgis, Lenos, Real Options: Managerial Flexibility and Strategy in Resource Al-
location(Cambridge, MA: MIT Press, 1997).
NOTE
- This is one definition of ROA; another definition is net earnings divided by
total assets. Given the second definition, ROA would be affected by leverage.