Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 9. Net Present Value and

Other Investment Criteria

© The McGraw−Hill^303

Companies, 2002

CHAPTER

9

Net Present Value and

Other Investment Criteria

In February 2000,Corning, Inc., announced plans to spend $750 million to

expand by 50 percent its manufacturing capacity of optical fiber, a crucial

component of today’s high-speed communications networks. Of that, $650

million would be spent to expand its facilities in North Carolina while another

$100 million would be spent to double the size of a smaller plant near

Melbourne, Australia. At the time, Corning was the world’s leading maker of

optical fiber with about 40 percent of the market. The expansion plans were

made amid a worldwide shortage of optical fiber stemming from the rapid

expansion of telephone and data communications networks.

Corning’s announcement offers an example of a capital budgeting decision.

An expansion such as this one, with a $750 million price tag, is obviously a major

undertaking, and the potential risks and rewards must be carefully weighed. In

this chapter, we discuss the basic tools used in making such decisions.

This chapter introduces you to the practice of capital budgeting. Back in

Chapter 1, we saw that increasing the value of the stock in a company is the goal

of financial management. Thus, what we need to learn is how to tell whether a

particular investment will achieve that or not. This chapter considers a variety of

techniques that are actually used in practice. More importantly, it shows how

many of these techniques can be misleading, and it explains why the net present

value approach is the right one.

n Chapter 1, we identified the three key areas of concern to the financial manager. The

first of these involved the question: What fixed assets should we buy? We called this

the capital budgeting decision. In this chapter, we begin to deal with the issues that

arise in answering this question.

The process of allocating or budgeting capital is usually more involved than just de-

ciding on whether or not to buy a particular fixed asset. We will frequently face broader

issues like whether or not we should launch a new product or enter a new market. Deci-

sions such as these will determine the nature of a firm’s operations and products for

years to come, primarily because fixed asset investments are generally long-lived and

not easily reversed once they are made.

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