Summary

Wise investment decisions are based on the net present value rule. In this paper we can think about how to apply the rule to practical capital investment decisions. Our task is threefold. First, what should be discounted? We know the answer in principle: discount cash flows. But useful forecasts of cash flows do not arrive on a silver platter. Often the financial manager has to do with “raw” data supplied by specialists in product design, production, marketing, and so on. This information has to be checked for completeness, consistency and accuracy. The financial manager has to ferret out hidden cash flows and take care to reject accounting entries that look like cash flows but truly are not. Second, how does the financial manager pull everything together into a forecast of overall, “bottom-line” cash flows? This requires careful tracking of taxes; changes in working capital; inflation; and the end-of-project “salvage values” of plant, property, and equipment. We will work through a realistic example. Third, how should a financial manager apply the net present value rule when choosing between investments in plant or equipment with different economic lives.

We showed how to transform the present value of an asset’s investment and operating costs into an equivalent annual cost, that is, the total cost per year of buying and operating the asset; how to use equivalent annual costs to decide when to replace aging plant or equipment. Choices between short- and long-lived production facilities, or between new and existing facilities, almost always involve project interactions, because a decision about one project cannot be separated from a decision about another, or from future decisions.