Introduction to Finance

mutually exclusive projects
,
 
two or more machines that perform the same 
function may be available from competing suppliers, possibly at diff erent costs and with dif-
ferent expected cash benefi ts. The fi nancial manager is responsible for choosing the best of 
these alternatives since only one can be chosen. Selecting one project precludes the other from 
being undertaken. 
Independent projects
do not compete with one another. They are to be 
evaluated based on their expected eff ect on shareholder wealth. All such projects that enhance 
shareholder wealth should be included in the fi rm’s capital budget.
In this chapter, we focus on only a small part of what is a complex topic. We present an 
overview of the capital budgeting process and some techniques used to evaluate potential 
investments. Then, we briefl y discuss the process of estimating the cash fl ows expected from a 
capital budgeting project. We then cover how a project’s risk can aff ect the evaluation process.
Identifying Potential Capital Budget Projects 
From Chapter 10, we know that the market value of an investment is the present value of 
future cash fl ows to be received from the investment. The net benefi t, or 
net present value 
(NPV)
, of an investment is the present value of a project’s cash fl ows minus its cost:
Net present value = Present value of cash fl ows – Cost of the project 
(17-1)
Should the net present value be positive (the investor pays less than the market value of the 
investment), the owner’s wealth increases by the amount of the net present value. If, for 
example, the present value of an asset’s cash fl ows is $100 and we can purchase it for only $80, 
our wealth will rise by $20. If, instead, we were foolish enough to pay $130 for the investment, 
our wealth will fall by $30. To maximize shareholder wealth, we need to fi nd assets or capital 
budgeting projects that have positive net present values.
Where do businesses fi nd attractive capital budgeting projects? Business managers need 
to search for projects related to the fi rm’s present lines of business or future plans. It would 
be foolish, for example, for a computer manufacturer to consider investing in land and mining 
equipment to prospect for gold. Despite management beliefs about future trends in gold prices 
and despite their confi dence in their ability to fi nd gold, such a project is far afi eld from the 
fi rm’s current markets, products, and expertise. 
Businesses should seek guidance to focus their search for capital budgeting projects. 
One popular corporate planning tool, known as