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.

In 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 deciding 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. Decisions 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.

Ross et al.: Fundamentals I IV. Capital Budgeting I 9. Net Present Value and I I © The McGraw-Hill of Corporate Finance, Sixth Other Investment Criteria Companies, 2002

Edition, Alternate Edition

274 PART FOUR Capital Budgeting

The most fundamental decision a business must make concerns its product line. What services will we offer or what will we sell? In what markets will we compete? What new products will we introduce? The answer to any of these questions will require that the firm commit its scarce and valuable capital to certain types of assets. As a result, all of these strategic issues fall under the general heading of capital budgeting. The process of capital budgeting could thus be given a more descriptive (not to mention impressive) name: strategic asset allocation.

For the reasons we have discussed, the capital budgeting question is probably the most important issue in corporate finance. How a firm chooses to finance its operations (the capital structure question) and how a firm manages its short-term operating activities (the working capital question) are certainly issues of concern, but it is the fixed assets that define the business of the firm. Airlines, for example, are airlines because they operate airplanes, regardless of how they finance them.

Any firm possesses a huge number of possible investments. Each possible investment is an option available to the firm. Some options are valuable and some are not. The essence of successful financial management, of course, is learning to identify which are which. With this in mind, our goal in this chapter is to introduce you to the techniques used to analyze potential business ventures to decide which are worth undertaking.

We present and compare a number of different procedures used in practice. Our primary goal is to acquaint you with the advantages and disadvantages of the various approaches. As we shall see, the most important concept in this area is the idea of net present value. We consider this next.

0 0

Post a comment