The Practice Of Capital Budgeting

Given that NPV seems to be telling us directly what we want to know, you might be wondering why there are so many other procedures and why alternative procedures are commonly used. Recall that we are trying to make an investment decision and that we are frequently operating under considerable uncertainty about the future. We can only estimate the NPV of an investment in this case. The resulting estimate can be very "soft," meaning that the true NPV might be quite different.

Because the true NPV is unknown, the astute financial manager seeks clues to help in assessing whether or not the estimated NPV is reliable. For this reason, firms would typically use multiple criteria for evaluating a proposal. For example, suppose we have an investment with a positive estimated NPV. Based on our experience with other projects, this one appears to have a short payback and a very high AAR. In this case, the different indicators seem to agree that it's "all systems go." Put another way, the payback and the AAR are consistent with the conclusion that the NPV is positive.

For example, in 2000, SouthernEra, a Toronto-based diamond mining and exploration company, announced that it was acquiring 54 percent of a platinum mining operation for about $10.3 million. Over the useful life of the mine, SouthernEra planned to spend a total of $86 million. It reported that its profitability studies showed an IRR of 36.3 percent with a net present value of $121.7 million at a 10 percent discount rate, along with a payback of five years. Based on these estimates, SouthernEra elected to go forward.

On the other hand, suppose we had a positive estimated NPV, a long payback, and a low AAR. This could still be a good investment, but it looks like we need to be much more careful in making the decision because we are getting conflicting signals. If the estimated NPV is based on projections in which we have little confidence, then further analysis is probably in order. The analysis performed by SouthernEra that we just discussed is a case in point. The profitability of the platinum mine depends crucially on future platinum prices, which can be quite volatile. We will consider how to evaluate NPV estimates in more detail in the next two chapters.

Capital expenditures by individual U.S. corporations add up to enormous sums for the economy as a whole. For example, in 2001, Chrysler Group (the U.S. arm of automaker DaimlerChrysler) said its capital spending would be about $30 billion over the five-year period 2002-2006. This amount was actually a reduction! Chip maker Texas Instruments sliced its 2001 budget to $2 billion, down from $2.8 billion in 2000. Not everyone was cutting, though. Rite-Aid, the drugstore chain, announced that it was raising its 2001 capital outlays to $230-$240 million from $140 million.

According to information released by the Commerce Department in 2001, capital investment for the economy as a whole was actually $1.038 trillion in 1999, $971 billion in 1998, and $872 billion in 1997. The total for the three years therefore exceeded $2.8 trillion! Given the sums at stake, it is not too surprising that careful analysis of capital expenditures is something at which all successful corporations seek to become adept.

There have been a number of surveys conducted asking firms what types of investment criteria they actually use. Table 9.6 summarizes the results of several of these. Panel A of the table is a historical comparison looking at the primary capital budgeting techniques used by large firms through time. In 1959, only 19 percent of the firms surveyed used either IRR or NPV, and 68 percent used either payback periods or accounting returns. It is clear that, by the 1980s, IRR and NPV had become the dominant criteria.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

S. Net Present Value and Other Investment Criteria

© The McGraw-Hill Companies, 2002

CHAPTER 9 Net Present Value and Other Investment Criteria

Capital Budgeting Techniques in Practice

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