Budgeting

For Good Measure

Multiple metrics can gauge the absolute -- as well as the relative -- return on investment.
Alix StuartJune 6, 2002

CFOs are using what academics consider better measures in their capital-budgeting analysis. According to a recent survey, more than 85 percent say they use net present value (NPV) analysis in at least three out of four decisions.

“Finance textbooks have taught for years that NPV is superior, but this is the first known survey to show it’s the preferred tool,” says co-author Patricia A. Ryan, a professor of corporate finance at Colorado State University. NPV is favored because it allows reinvestment rates to better reflect external capital costs.

There’s still room for improvement. Only 21.9 percent of the respondents said they frequently use modified IRR (internal rate of return), a purer analysis than NPV because it can accommodate differing reinvestment and financing rates. And fewer than 12 percent said they regularly use real options.

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Of course, many CFOs don’t limit themselves to a single measure. “It’s situational,” says Howard McLure, CFO of Caremark Rx Inc. While NPV alone is fine for investments that don’t directly create revenue for the prescription benefits management company, he says, “in a revenue-producing situation, I prefer to see both NPV and IRR.”