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Home > Balance Sheets Best Practice > Capital Budgeting: The Dominance of Net Present Value

Balance Sheets Best Practice

Capital Budgeting: The Dominance of Net Present Value

by Harold Bierman, Jr

Executive 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 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, it should be remembered that the only relevant cash flows of a period are after all tax effects have been taken into account.

The definition of incremental cash flows is relatively straightforward: If the item changes the bank account or cash balance, it is a cash flow. This definition includes opportunity costs (the value of alternative uses). For example, if a warehouse is used for a new product and the alternative is to rent the space, the lost rentals should be counted as an opportunity cost in computing the incremental cash flows of using the space.

The computations in this article make several assumptions that are convenient and that simplify the analysis:

  • Capital can be borrowed and lent at the same rate.

  • The cash inflows and outflows occur at the beginning or end of each period, rather than continuously during the periods.

  • The cash flows are certain, and no risk adjustment is necessary.

In addition, in choosing the methods of analysis and implementation, it is assumed that the objective is to maximize the wellbeing of stockholders, and more wealth is better than less.

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Further reading

Books:

  • Bierman, Harold. Implementation of Capital Budgeting Techniques. Financial Management Survey & Synthesis Series. Tampa, FL: FMA, 1986.
  • Bierman, Harold, Jr, and Seymour Smidt. The Capital Budgeting Decision. 9th ed. New York: Routledge, 2007.
  • Bierman, Harold, Jr, and Seymour Smidt. Advanced Capital Budgeting. New York: Routledge, 2007.
  • Stanford Research Institute. Financial Management in Transition. Menlo Park, CA, 1966.

Articles:

  • Graham, John R., and Campbell R. Harvey. “The theory and practice of corporate finance: Evidence from the field.” Journal of Financial Economics 60:2–3 (May 2001): 187–243. Online at: dx.doi.org/10.1016/S0304-405X(01)00044-7
  • Hastie, K. L. “One businessman’s view of capital budgeting.” Financial Management 3:4 (Winter 1974): 36–44.

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