Introduction to Finance

DISCUSSION QUESTION 1
Name a company and suggest a capital budgeting project it should consider doing. Explain 
why you believe the project is appropriate and good idea for the company to pursue.
LEARNING ACTIVITY
1. Details of investments can be seen in annual reports and news releases, both of which 
can be accessed via the fi rms’ websites, http://www.wellsfargo.com, http://www.
merck.com, http://www.abc.xyz, and http://www.chick-fi l-a.com.
2. Visit the Environmental Protection Agency’s SmartWay program to see what options 
exist to help businesses lower transportation costs: http://www.epa.gov/smartway/.
17.3
Capital Budgeting Techniques—
Net Present Value
FINANCE
Appropriate methods or techniques are required to evaluate capital budgeting projects 
so that wealth-maximizing decisions can be made. The techniques used should refl ect the 
time value of money, since cash outlays for plant and equipment occur now while the benefi ts 
occur in the future. Five methods are widely utilized: net present value (NPV), internal rate of 
return (IRR), modifi ed internal rate of return (MIRR), profi tability index (PI), and the payback 
period. Of these fi ve methods, the payback period is the 
least
preferable because it does not 
account for the time value of money.
8
Vincent Ryan, “Sucking It Up,” 
CFO
, (April 2008), pp. 66–73; S. L. Mintz, “What Goes Down Will Come Up,” 
CFO
, (December 2008), pp. 51–55.

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C H A PT E R 1 7 Capital Budgeting Analysis
The net present value (NPV) method is arguably the best method to evaluate capital 
budgeting projects. A project’s NPV is calculated as the present value (PV) of all cash fl ows 
for the life of the project less the initial investment or outlay as we saw in equation 17-1. It 
considers the time value of money and includes all of the project’s cash fl ows in the analysis. 
In addition, its value measures the project’s dollar impact on shareholder wealth. The NPV 
measures the expected dollar change in shareholder wealth from doing the project. That is, a 
project with an NPV of $1 million is expected to increase shareholder wealth by $1 million. 
Thus, projects with positive NPVs are expected to add to shareholder wealth while projects 
with negative NPVs should be shunned.
To apply the NPV method, we need to know the project’s estimated cash fl ows and the 
required rate of return in order to discount the cash fl ow. We discuss methods of estimating 
cash fl ows in the next chapter. The required rate of return should refl ect the cost of long-term 
debt and equity capital funds for projects with the same risk as the one under consideration. In 
the following example, we’ll assume that the required rate of return, or