Imagine you are Jim, a small business owner who runs the local bakery. You and your wife Jane are considering buying a new oven for the bakery. One oven costs $10,000 today; the other oven costs $12,000, but you only have to pay a $2,000 deposit, and the rest you will pay in installments over the next five years. Which one do you decide to purchase? What if another bakery across town is put up for sale, would you and your wife consider purchasing it and expanding your business? What if you own both bakeries and one is becoming more difficult to run, when does it make sense to abandon it? These types of decisions are known as capital budgeting decisions and are an important part of the long-term financial planning of any business.
Capital budgeting is the term that describes the long-term planning and decision-making associated with investments such as new property, plants and machinery, replacing old machinery, creating new products, and undertaking research and development projects.
Capital budgeting tools help managers plan for financing (or the acquisition of needed funds) and to make decisions about what opportunities a company should pursue. In our introduction (see Finance) we suggest that the goal of any successful financial manager should be to increase the value of the firm to shareholders. As a result, most financial managers make capital budgeting decisions by evaluating how an investment decision will impact the value of the firm; that is, will an investment decision make the firm's shareholders better off by increasing the value of the firm?
The method most commonly used to determine whether a project should be accepted or not is called Net Present Value (NPV). The NPV method takes all of the future cash inflows and outflows associated with a project and discounts them to the present period using an appropriate discount rate (we assume all cash flows are after tax, typically). If the net present value of a project is negative, this suggests that the project will decrease firm value and, as a result, it should not be accepted. A positive NPV project may be accepted, but is often subject to further criteria. For example, when a business must choose between two projects both with a positive NPV, they may choose the project with the higher NPV, the lower payback period, the higher profitability index, or a higher equivalent annual annuity. Businesses may also have in place policies, for example, that a project must have a rate of return that is higher than some threshold in order to be accepted.