The chapter adopts the corporate objectives developed in Chapter 2where it was shown that the appropriate goal is “to maximise the value of the firm subject to maximising the share price” (
Thistranslates to a capital budgeting context as “to maximise the present value of the firm’s investments subject to maximising their net present value” (
To develop the argument we first need to show why there is anunderinvestment bias in standard investment selection criteria, in particular a propensity for conventional capital budgeting decision rules to beinfluenced by the logic of capital rationing even when nonrationingconditions are explicitly assumed to hold.Symptomatic of this bias are three widely held misconceptions thatwill be later discussed in some detail. These are the assumption i) that, for a project to be acceptable, it must in practice have a positive, asdistinct from a nonnegative, net present value (the "
") ii) that the reinvestment opportunities for a project'sintermediate and terminal cash flows are relevant to the project's degree of acceptability, (the "
") and iii) that a project ismore desirable the more efficient its use of capital, in the sense that,
for a given NPV
, a quick payback is preferred to a slow payback, and ahigh IRR or Profitability Index preferred to a low one (the "
).To illustrate these fallacies consider the two mutually exclusive projects, A1 and A2, in Table 1 available to a company operating innormal, nonrationing conditions. It is assumed that neither project will bereplaced on completion. The projects have identical positive NPVs and both are obviously acceptable. Conventional theory would suggest thatthey are equally attractive or, possibly, that the project with the lower outlay and shorter life should be favoured. To test the intuitive appeal of this interpretation, the above problem was presented to a group of studentswho had successfully completed a standard introductory course inBusiness Finance. 92% of the students indicated either that A1 is lessattractive than A2 or that, at best, the two are equally desirable. The mainreasons given for favouring A2 were that the investment capital "saved"might be better employed in other projects, and that A2 is more desirable because it employs less capital to generate the same amount of NPV.