Finance Reading: NPV and Capital Budgeting

This reading introduces the capital allocation process. It presents the valuation tools and financial metrics used by companies to evaluate investment opportunities. The reading begins with the relatively simple problem of evaluating a single investment proposal using net present value (NPV) and relates NPV to the concept of value maximization. It then considers alternative metrics and examines the pros and cons of each. Each metric is compared to NPV in execution and likely performance. The reading then proceeds to a more complicated problem commonly faced by managers: how to choose among multiple projects, often in the presence of budgetary or managerial constraints. Students are given a framework for comparing and ranking projects utilizing the various metrics. A brief detour links NPV to the capital markets and, specifically, to risk and expected returns. The reading concludes with an overview of real-world complications that can limit the reliability of the various financial metrics used throughout the reading, and considers ways to adapt metrics and methodologies accordingly. The reading contains seven web-based interactive illustrations. Five of these provide an application and visual representation of important tools and metrics covered in the reading, including NPV, internal rate of return, payback period, and the profitability index. Two additional interactives illustrate the complexity of making capital budgeting decisions in a complex operating environment with multiple investment opportunities. The first of these examines the implications of using a single hurdle rate to evaluate projects of varying degrees of riskiness; the latter illustrates the difficulties involved in selecting the value maximizing set of opportunities in the presence of a budget constraint and/or in situations where one or more projects monopolize the available budget.

• Profitability
• Financial analysis
• Capital budgeting
• Investment management