Capital Budgeting: The Dominance of Net Present Value

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Capital Budgeting: The Dominance of Net Present Value

by Harold Bierman, Jr

Executive Summary

* The time value of money is highly relevant.

* Net present value (NPV) is a very reliable method of analysis.

* Use incremental cash flows.

* NPV profile is an excellent 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

Capital Budgeting: The Dominance of Net Present Value 2 of 8

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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,