As a financial manager, we will have to decide whether projects make sense financially. For a project to make sense, we must see if we get a reasonable return. What is reasonable varies with the type of company it is, what the competition is, and a number of other factors. Portfolio managers for securities usually have some required rate of return given to them, as we did when we were working bond valuation problems, but capital budgeting in a corporation is more organic and creative. There may be intangible factors such as market position that force us to accept a less than optimal return or there may be a long investment horizon, such as there is in pharmaceutical companies when it comes to R&D. (The process of creating a new drug can take a long time, during which the money just runs out like water. Once a breakthrough drug is found, however, the return is enormous. You may not think of companies like Johnson and Johnson, Lilly or Merck as gamblers, but they play long shots every day.) As the financial person, it is always our job to keep our eye on return.
We will look at several different methods of evaluating a project. While the Net Present Value is the one that is the most accurate, sometimes it is easier to use different criteria. Many executives like the Payback rule, which tells us how long it takes to get our investment back, while accountants usually like the accounting return rule because it uses numbers that are readily available from the regular accounting papers of the firm. The Internal Rate of Return method is, in essence, a variation on the Net Present Value. Here the approach is more like that of the stock analyst. You figure out the expected rate of return on the project and see if it is better than your required rate. The profitability Index isn’t used that much any more, but older executives and executives in older industries such as utilities still use it, so you need to understand it.
Once we have finished looking at all these different ways of evaluating projects, we will then talk about the capital budgeting process in a more strategic way.
When you finish your study of this chapter, you should know:
The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!
Average accounting return
Discounted cash flow criteria
Discounted Cash Flow valuation
Internal rate of return
Multiple rates of return
Mutually exclusive investment decisions
Net Present Value
Net present value profile
Profitability index (PI)
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Be sure that you know the material in Table 8.6 on Page 228
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