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NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

The investment decision, also known as capital budgeting, is central to the success of the company. We have already seen that capital investments sometimes absorb substantial amounts of cash; they also have very longterm consequences. The assets you buy today may determine the business you are in many years hence.

For some investment projects substantial is an understatement. Consider the following examples:

_ Construction of the Channel Tunnel linking England and France cost about $15 billion from 1986 to 1994.

_ The cost of bringing one new prescription drug to market was estimated to be at least $300 million.

_ The development cost of Ford s world car, the Mondeo, was about $6 billion. _ Production and merchandising costs for three new Star Wars movies will amount to about $3 billion.

_ The future development cost of a super-jumbo jet airliner, seating 600 to 800 passengers, has been estimated at over $10 billion.

_ TAPS, The Alaska Pipeline System, which brings crude oil from Prudhoe Bay to Valdez on the southern coast of Alaska, cost $9 billion.

Notice from these examples of big capital projects that many projects require heavy investment in intangible assets. The costs of drug development are almost all research and testing, for example, and much of the development of Ford s Mondeo went into design and testing. Any expenditure made in the hope of generating more cash later can be called a capital investment project, regardless of whether the cash outlay goes to tangible or intangible assets.

A company s shareholders prefer to be rich rather than poor. Therefore, they want the firm to invest in every project that is worth more than it costs. The difference between a project s value and its cost is termed the net present value. Companies can best help their shareholders by investing in projects with a positive net present value.

We start this material by showing how to calculate the net present value of a simple investment project. We also examine other criteria that companies sometimes consider when evaluating investments, such as the project s payback period or book rate of return. We will see that these are little better than rules of thumb. Although there is a place for rules of thumb in this world, an engineer needs something more accurate when designing a 100-story building, and a financial manager needs more than a rule of thumb when making a substantial capital investment decision.

Instead of calculating a project s net present value, companies sometimes compare the expected rate of return from investing in a project with the return that shareholders could earn on equivalent-risk investments in the capital market. Companies accept only those projects that provide a higher return than shareholders could earn for themselves.

This rate of return rule generally gives the same answers as the net present value rule but, as we shall see, it has some pitfalls. We then turn to more complex issues such as project interactions. These occur when a company is obliged to choose between two or more competing proposals; if it accepts one proposal, it cannot take the other. For example, a company may need to choose between buying an expensive, durable machine or a cheap and short-lived one. We will show how the net present value criterion can be used to make such choices.

Sometimes the firm may be forced to make choices because it does not have enough money to take on every project that it would like. We will explain how to maximize shareholder wealth when capital is rationed. It turns out that the solution is to pick the projects that have the highest net present value per dollar invested. This measure is known as the profitability index. After studying this material you should be able to

_ Calculate the net present value of an investment.

_ Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule.

_ Explain why the payback rule and book rate of return rule don t always make shareholders better off.

_ Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with equal lives, and (c) when to replace equipment.

_ Calculate the profitability index and use it to choose between projects when funds are limited.