Product Overview

A construction company that serves a 20-county area of eastern Georgia (United States) has as its main source of revenue the manufacture and placement of asphaltic concrete used in road construction. Thanks to a new, multiyear, state-funded highway program, the company needs to expand its asphalt production capacity and is considering two options: purchasing a new portable drum-mix plant or purchasing a used (nonportable) batch plant. The company uses net present value (NPV), payback, profitability index (the ratio of the present value of future cash flows divided by the initial investment), and internal rate of return (IRR) to evaluate capital expenditures of this type. Pro forma cash flow statements (Excel spreadsheet models) are provided for each option. The decision is complicated by conflicting messages from the various evaluation criteria and uncertainty in some of the inputs.

Learning Objectives

1. The assumptions behind the use of NPV to compare alternatives that differ in terms of size of investment and time horizon 2. The relationship between NPV and IRR in comparing mutually exclusive alternatives 3. The limitations of other capital-budgeting evaluation criteria such as payback and alternatives to IRR that try to capture the return on investment 4. The use of a risk premium in the discount rate (risk-adjusted hurdle rate) versus sensitivity analysis or the explicit modeling of uncertainty to account for risk 5. The role of sensitivity analysis (such as a tornado diagram) to identify key sources of risk