Where Do Good Projects Come From

In the process of analyzing new investments in the preceding chapters, we have contended that good projects have a positive net present value and earn an internal rate of return greater than the hurdle rate. While these criteria are certainly valid from a measurement standpoint, they do not address the deeper questions about good projects including the economic conditions that make for a "good" project and why it is that some firms have a more ready supply of "good" projects than others.

Implicit in the definition of a good project — one that earns a return that is greater than that earned on investments of equivalent risk — is the existence of super-normal returns to the business considering the project. In a competitive market for real investments, the existence of these excess returns should act as a magnet, attracting competitors to take on similar investments. In the process, the excess returns should dissipate over time; how quickly they dissipate will depend on the ease with which competition can enter the market and provide close substitutes and on the magnitude of any differential advantages that the business with the good projects might possess. Take an extreme scenario, whereby the business with the good projects has no differential advantage in cost or product quality over its competitors, and new competitors can enter the market easily and at low cost to provide substitutes. In this case the super-normal returns on these projects should disappear very quickly.

An integral basis for the existence of a "good" project is the creation and maintenance of barriers to new or existing competitors taking on equivalent or similar projects. These barriers can take different forms, including a. Economies of scale: Some projects might earn high returns only if they are done on a "large" scale, thus restricting competition from smaller companies. In such cases, large companies in this line of business may be able to continue to earn super-normal returns on their projects because smaller competitors will not be able to replicate them.

b. Cost Advantages: A business might work at establishing a cost advantage over its competitors, either by being more efficient or by taking advantage of arrangements that its competitors cannot use. For example, in the late 1980s, Southwest Airlines was able to establish a cost advantage over its larger competitors, such as American and United Airlines by using non-union employees, the company exploited this cost advantage to earn much higher returns.

c. Capital Requirements: Entry into some businesses might require such large investments that it discourages competitors from entering, even though projects in those businesses may earn above-market returns. For example, assume that Boeing is faced with a large number of high-return projects in the aerospace business. While this scenario would normally attract competitors, the huge initial investment needed to enter this business would enable Boeing to continue to earn these high returns.

d. Product Differentiation: Some businesses continue to earn excess returns by differentiating their products from those of their competitors, leading to either higher profit margins or higher sales. This differentiation can be created in a number of ways -through effective advertising and promotion (Coca Cola), technical expertise (Sony), better service (Nordstrom) and responsiveness to customer needs.

e. Access to Distribution Channels: Those firms that have much better access to the distribution channels for their products than their competitors are better able to earn excess returns. In some cases, the restricted access to outsiders is due to tradition or loyalty to existing competitors. In other cases, the firm may actually own the distribution channel, and competitors may not be able to develop their own distribution channels because the costs are prohibitive.

f. Legal and Government Barriers: In some cases, a firm may be able to exploit investment opportunities without worrying about competition because of restrictions on competitors from product patents the firm may own to government restrictions on competitive entry. These arise, for instance, when companies are allowed to patent products or services, and gain the exclusive right to provide them over the patent life.

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  • Arvi
    Where do projects come from finance?
    8 years ago

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