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Scale is a fundamental consideration when evaluating and ranking capital investment projects. Beaves [2, 3], Lin [6], and Shull [7] have noted that the definition of "project scale" is key to the definition of "modified" or "overall" rates of return earned by projects. This article demonstrates that the impact of how project scale is defined extends beyond the calculation of rate of return decision criteria. Given its importance to the capital budgeting process, it is somewhat surprising that project scale has not been clearly and consistently defined. The purpose of this article is to raise awareness of the need for a uniform definition of project scale. Although three potential measures of project scale are compared, this article does not provide a mathematical proof that one of these definitions is correct and the others are not. Nonetheless, a strong argument is made for a particular measure of project scale as well as for the importance of having a single, uniform definition of that concept.
DEFINING PROJECT SCALE
Investment theory generally assumes that the scale of one's investment in a particular asset or security is infinitely variable. In that case, the performance of a particular investment can be measured by its rate of return, a decision criterion that is independent of investment scale. Investment theory is not, however, directly applicable to capital budgeting where the scale of each investment opportunity or project is assumed to be fixed rather than variable. Because scale is critical in the capital budgeting process, the preferred measure of project performance is net present value (NPV), a decision criterion that reflects scale. Project scale is a key element in defining several capital budgeting concepts. Given the importance of scale to capital budgeting analysis, it is of some concern that project scale has not been clearly and uniformly defined. This article explores how three possible measures of project scale relate to one another and to several important capital budgeting concepts. A case is then made for one of these measures as the preferred definition for project scale.
A project is represented as a stream of expected cash flows, a^sub t^ (where t = O through n). Decision makers are assumed to be able to assess the risk of each project and to assign...