The Basic Idea

An investment is worth undertaking if it creates value for its owners. In the most general sense, we create value by identifying an investment worth more in the marketplace than it costs us to acquire. How can something be worth more than it costs? It's a case of the whole being worth more than the cost of the parts.

For example, suppose you buy a run-down house for $25,000 and spend another $25,000 on painters, plumbers, and so on to get it fixed up. Your total investment is $50,000. When the work is completed, you place the house back on the market and find that it's worth $60,000. The market value ($60,000) exceeds the cost ($50,000) by $10,000. What you have done here is to act as a manager and bring together some fixed assets (a house), some labor (plumbers, carpenters, and others), and some materials (carpeting, paint, and so on). The net result is that you have created $10,000 in value. Put another way, this $10,000 is the value added by management.

With our house example, it turned out after the fact that $10,000 in value had been created. Things thus worked out very nicely. The real challenge, of course, would have been to somehow identify ahead of time whether or not investing the necessary $50,000 was a good idea in the first place. This is what capital budgeting is all about, namely,

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 Companies, 2002

CHAPTER 9 Net Present Value and Other Investment Criteria

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