Finance
Capital Budgeting
Evaluating long-term investments — NPV, IRR, payback period
Capital budgeting is the process of evaluating long-term investments (projects, equipment, expansion). Major techniques. (1) Net Present Value (NPV): present value of cash flows minus initial cost. Accept if > 0. (2) Internal Rate of Return (IRR): discount rate making NPV = 0. Accept if > cost of capital. (3) Payback period: time to recover initial investment. Simple but ignores time value. (4) Profitability index: NPV / initial investment. Choose highest. NPV: theoretically best. Used in: corporate finance, business decisions, investment evaluation. Foundation of financial analysis.
- NPVSum of discounted cash flows minus cost
- IRRDiscount rate making NPV = 0
- Payback periodTime to recover initial investment
- NPV decision ruleAccept if NPV > 0
- IRR ruleAccept if IRR > cost of capital
- NPV preferredTheoretically most accurate
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Why capital budgeting matters
- Corporate finance. Foundation.
- Investment decisions. Evaluating projects.
- Business strategy. Long-term planning.
- Mergers and acquisitions. Valuation.
- Public sector. Infrastructure decisions.
- Personal investing. Real estate, education ROI.
- Education. Foundational finance.
Common misconceptions
- Higher IRR always better. NPV better metric.
- Payback period sufficient. Ignores time value.
- Discount rate same for all. Risk-specific.
- Cash flows certain. Always uncertain.
- Easy to apply. Forecasts difficult.
- NPV captures everything. Real options, strategic value extra.
Frequently asked questions
What's capital budgeting?
Process of evaluating long-term investment decisions. Equipment purchases, new factories, R&D projects, acquisitions, expansion. Different from operating decisions (short-term). Long-term implications. Major techniques: NPV, IRR, payback period, profitability index. Used in: corporate finance, business strategy. Critical for: companies allocating capital efficiently.
What's NPV?
Net Present Value. Present value of cash flows minus initial cost. NPV = -C₀ + Σ Cₜ/(1+r)^t. Where C₀ = initial cost, Cₜ = cash flow at time t, r = discount rate. Discount rate: typically cost of capital. Decision rule: accept if NPV > 0 (creates value); reject if < 0. NPV theoretically best metric. Considers all cash flows, time value of money, risk via discount rate.
What's IRR?
Internal Rate of Return. Discount rate making NPV = 0. Decision rule. Accept if IRR > cost of capital. Reject if < cost of capital. Intuitive: like effective rate of return on project. Computed: solve algebraically or iteratively. Issues. (1) Multiple IRRs possible. (2) Misleading for mutually exclusive projects. (3) Reinvestment assumption questionable. NPV preferred for ranking.
What's payback period?
Time to recover initial investment. Simple to calculate. Cumulative cash flows reach initial cost. Easy to communicate. Limitations. (1) Ignores time value of money. (2) Ignores cash flows beyond payback. (3) Arbitrary cutoff. (4) Doesn't account for risk. Useful: liquidity-conscious decisions. Discounted payback: improvement (uses time value).
How is discount rate determined?
Cost of capital. WACC (Weighted Average Cost of Capital). Average of debt cost (interest rate) and equity cost (CAPM-based). Risk-adjusted. Higher risk projects: higher discount rate. Industry-specific. Determining accurately: critical (small differences large NPV impact). Sensitivity analysis: shows NPV at different rates.
What about real options?
Modern approach. Incorporates flexibility/options into capital budgeting. Examples. (1) Option to expand: invest small initially; expand if successful. (2) Option to abandon. (3) Option to delay. NPV alone undervalues these. Real options: significant value in many projects. Black-Scholes-like methods to value. Beyond basic NPV.
What's the limitations?
Several. (1) Cash flow forecasts uncertain. (2) Discount rate hard to determine accurately. (3) Risk assessment difficult. (4) Strategic value (entry, learning) may not be captured. (5) Scenario analysis: complement NPV. (6) Different metrics give different answers. Real-world: combines quantitative + qualitative judgment. NPV: imperfect but most defensible.