Capital Budgeting: The Dominance of Net Present Value
Essay by Nicolas • June 12, 2011 • Case Study • 3,225 Words (13 Pages) • 2,196 Views
Capital Budgeting: The Dominance of Net Present Value 1 of 8
www.qfinance.com
Capital Budgeting: The Dominance of Net Present Value
by Harold Bierman, Jr
Executive Summary
* The time value of money is highly relevant.
* Net present value (NPV) is a very reliable method of analysis.
* Use incremental cash flows.
* NPV profile is an excellent summary.
Introduction
A capital budgeting decision is characterized by costs and benefits that are spread out over several time
periods. This leads to a requirement that the time value of money be considered in order to evaluate
the alternatives correctly. Although to make decisions we must consider risks as well as time value, I
restrict the discussion to situations in which the costs and benefits are known with certainty. There are
sufficient difficulties in just taking the time value of money into consideration. Moreover, when the cash
flows are allowed to be uncertain, I would suggest the use of procedures that are based on the initial
recommendations made with the certainty assumption, so nothing is lost by making the assumption of
certainty.
A financial executive made the following interesting observation (Bierman, 1986):
"The real challenge is creativity and invention, not analysis. Timely execution of projects by entrepreneurial
managers is also more critical than sophistication of analytical budgeting techniques."
Rate of Discount
We shall use the term time value of money to describe the discount rate. One possibility is to use the rate
of interest associated with default-free securities. This rate does not include an adjustment for the risk of
default; thus risk, if present, would be handled separately from the time discounting. In some situations,
it is convenient to use the firm's borrowing rate (the marginal cost of borrowing funds). The objective of
the discounting process is to take the time value of money into consideration. We want to find the present
equivalent of future sums, neglecting risk considerations.
Although the average cost of capital is an important concept that should be understood by all managers and
is useful in deciding on the financing mix, I do not advocate its general use in evaluating all investments.
Different investments have different risks.
Dependent and Independent Investments
In evaluating the investment proposals presented to management, it is important to be aware of the
possible interrelationships between pairs of investment proposals. An investment proposal will be said to be
economically independent of a second investment if the cash flows (or equivalently the costs and benefits)
expected from the first investment would be the same regardless of whether the second investment were
accepted or rejected. If the cash flows associated with the first investment are affected by the decision to
accept or reject the second investment, the first investment is said to be economically dependent on the
second.
In order for investment A to be economically independent of investment B, two conditions must be satisfied.
First, it must be technically possible to undertake investment A whether or not investment B is accepted.
Second, the net benefits to be expected from the first investment must not be affected by the acceptance
or rejection of the second. The dependency relationship can be classified further. In the extreme case
where the potential benefits to be derived from the first investment will completely disappear if the second
Capital Budgeting: The Dominance of Net Present Value 2 of 8
www.qfinance.com
investment is accepted, or where it is technically impossible to undertake the first when the second has been
accepted, the two investments are said to be mutually exclusive.
Statistical Dependence
It is possible for two or more investments to be economically independent but statistically dependent.
Statistical dependence is said to be present if the cash flows from two or more investments would be
affected by some external event or happening whose occurrence is uncertain. For example, a firm could
produce high-priced yachts and expensive cars. The investment decisions affecting these two product
lines are economically independent. However, the fortunes of both activities are closely associated with
high business activity and a large amount of discretionary income for the "rich" people. This statistical
dependence may affect the risk of investments in these product lines because the swings of profitability
of a firm with these two product lines will be wider than those of a firm with two product lines having less
statistical dependence.
Incremental Cash Flows
Investments should be analyzed using after-tax incremental cash flows. Although we shall assume zero
taxes so that we can concentrate on the technique of analysis,
...
...