Introduction to Finance

LO 17.6
Calculate profi tability index, describe what it measures, and explain how it is used 
in capital budgeting analysis.
LO 17.7
Calculate payback, describe what it measures, and explain how it is used in capital 
budgeting analysis.
LO 17.8
Explain the confl icts that arise between project rankings determined by the various 
capital budgeting methods, and describe the practical issues that arise between 
theory and practice when using the capital budgeting methods.
LO 17.9
Explain how relevant cash fl ows are determined for capital budgeting decision 
purposes.
LO 17.10
Describe how managers can be held accountable for their project’s cash fl ow 
estimates.
LO 17.11
Discuss how a project’s risk can be incorporated into capital budgeting analysis.
W H E R E W E H A V E B E E N . . .
In Chapter 13, at the beginning of the fi nancial management section of this book, we con-
sidered how fi rms will have a mission or vision statement; that is, a reason for being. This 
chapter will examine how fi rms can “put feet to their words” and make decisions to purchase 
fi xed assets and pursue strategies to help them fulfi ll their mission. The previous two chapters 

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17.1 Mission, Vision, and Capital Budgeting
521
examined how a fi rm should manage and fi nance its current assets. Now our focus will shift 
to fi xed assets.
W H E R E W E A R E G O I N G . . .
Once a fi rm decides which fi xed assets and corporate strategies to pursue, it must fi nance 
them. This will be the focus of Chapter 18, “Capital Structure and the Cost of Capital.”
H O W T H I S C H A P T E R A P P L I E S TO M E . . .
Capital budgeting analysis is a framework for evaluating all business decisions; it is not 
only a tool for the “fi nancial” types. Proper analysis will identify relevant cash fl ows and 
an appropriate discount rate to refl ect the strategy’s risk and will compare the project’s 
benefi ts and costs by considering the time value of money. It causes managers to consider 
more than a “feel good” or “sounds right” criterion for investing in projects. Whether the 
investment is one in a business strategy, building a new warehouse, seeking fuel-effi
cient 
methods of doing business, upgrading information technology systems, or investing in 
human resources, we should try to quantify the benefi ts and cost of these choices in order 
to evaluate them properly.
To achieve success over time, a fi rm’s managers must identify and invest in the following:
Projects that provide positive net present values to maximize shareholder wealth. 
Good ideas become good strategies when the numbers, such as cash fl ow forecasts, show 
the likelihood of shareholder wealth increasing because of the project. The fi rm’s value will 
rise when a capital investment provides the fi rm with positive cash fl ows after the investment 
has been recovered, the cost of obtaining the necessary fi nancing has been paid, and the timing 
of the project’s cash fl ows has been taken into consideration.
17.1
Mission, Vision, and Capital Budgeting
As fi rst discussed in Chapter 13, every fi rm should have a vision or mission—meaning, a 
reason for being. To implement its mission, a fi rm needs to have a competitive advantage. 
A competitive advantage is the reason why a fi rm’s customers are willing to purchase its 
products or services rather than those of another fi rm. Large corporations spend millions on 
researching their customers and competitors to gather information they can use to maintain 
or expand their competitive advantage. Integral to the process of maintaining or expanding 
a fi rm’s competitive advantage are its decisions concerning what products to off er and what 
markets or market segments to serve.