College of Business Administration
University of Pittsburgh

Capital Budgeting: Investment Criteria

BUSFIN 1030

Introduction to Finance
Capital Budgeting Decisions

Examples of decisions addressed:

1. What products should the firm sell?

2. In what markets should the firm compete?

3. What new products should the firm introduce?

Roles of managers:

4. Identify and invest in products and business acquisitions that will maximize the current market value of equity.

5. Learn to identify which products will succeed and which will fail.

The capital markets will send the firm signals about how well it is doing.

Net Present Value (NPV)

The net present value is the difference between the market value of an investment and its cost.

[pic]

NPV is a measure of the amount of market value created by undertaking an investment project.

The interest rate, r, will reflect the risk of the cash flows.

Finding the market value of the investment

6. Use discounted cash flow valuation (calculate present values).

7. Compute the present values of future cash flows

Net Present Value Rule (NPV): An investment should be accepted if the net present value is positive and rejected if the net present value is negative.

Positive NPV projects create shareholder value.
Using NPV

The marketing department of your firm is considering whether to invest in a new product. The costs associated with introducing this new product and the expected cash flows over the next four years are listed below. (Assume these cash flows are 100% likely). The appropriate discount rate for these cash flows is 20% per year. Should the firm invest in this new product?

Costs: ($ million)
Promotion and advertising 100.00
Production & related costs 400.00
Other 100.00
Total Cost 600.00

|