Investment Decisions: Capital Budgeting
Where the FM chain arrives
This chapter is the payoff of the cumulative structure the method chapter described. Cost of capital, computed two chapters ago, becomes the discount rate here. Capital structure, examined in the previous chapter, determines how a project's financing affects the risk borne by shareholders. Now those pieces combine into the actual decision a firm makes: given a discount rate and a set of estimated cash flows, should this specific project be undertaken.
Capital budgeting is the process of evaluating and selecting long-term investment proposals whose returns are expected to accrue over several years, distinguishing it from working capital decisions, examined in the next chapter, which concern short-term, recurring, self-liquidating commitments.
Getting the cash flows right before applying any technique
Every capital budgeting technique operates on estimated cash flows, and the single most consequential source of error in this chapter is not misapplying a formula but feeding a technique the wrong cash flows in the first place. Three disciplines matter here, worth stating before any technique at all.
Use cash flows, not accounting profit. Depreciation is a non-cash accounting charge; it must be added back to accounting profit after tax to arrive at the operating cash flow relevant to capital budgeting, even though depreciation itself matters indirectly, since it reduces taxable profit and therefore reduces the actual tax paid — the correct treatment is to compute profit after tax including the depreciation deduction, and then add depreciation back, capturing its genuine tax-shield benefit without treating it as an actual cash outflow itself.
Include only incremental, relevant cash flows. A cash flow is relevant to a capital budgeting decision only if it changes as a direct consequence of accepting the project. Sunk costs — expenditure already incurred before the decision point, such as money already spent on a feasibility study — are irrelevant, because they do not change regardless of whether the project is accepted or rejected now. Opportunity costs, by contrast, are relevant even though they involve no new cash outlay — if a project uses an asset the firm already owns and could otherwise have sold or used for another purpose, the value forgone by using it for this project instead is a genuine cost of undertaking it. Working capital invested to support a project's operations, and recovered at the end of the project's life, must also be included as a cash outflow at the start and a cash inflow at termination.
Structure cash flows into three stages. The initial outlay at time zero includes the cost of the asset, installation, and any initial working capital, net of the sale proceeds of any old asset being replaced along with the tax effect of that sale. The annual operating cash flows over the project's life are the incremental after-tax cash flows the project generates each year. The terminal cash flow at the end of the project's life includes the salvage value of the asset, net of tax on any profit or loss on its disposal relative to its book value at that point, plus recovery of the working capital invested at the start.
Non-discounting techniques
Two techniques ignore the time value of money entirely, valued mainly for their simplicity rather than their theoretical soundness.
The payback period is the time required for a project's cumulative cash inflows to recover the initial outlay. It is simple to compute and communicates a rough sense of liquidity and risk — a shorter payback period generally implies the initial investment is recovered, and exposed to risk, for a shorter time. Its central weakness is that it ignores the time value of money and, more seriously, ignores all cash flows occurring after the payback period entirely, which can favour a project that recovers its outlay quickly but then generates comparatively little further value, over a project with a longer payback but substantially larger cash flows in its later years.
The accounting rate of return (ARR), average accounting profit after tax divided by average or initial investment, expressed as a percentage, has the advantage of being based on familiar accounting figures, but shares the payback period's weakness of ignoring the time value of money, and additionally uses accounting profit rather than cash flow, reintroducing exactly the depreciation and accrual distortions the discounted techniques are specifically designed to avoid.
Discounting techniques
Discounting techniques recognise that a rupee received later is worth less than a rupee received now, and discount each future cash flow back to present value using the firm's cost of capital, or, for a specific project, its risk-appropriate discount rate.
Net present value (NPV) is the sum of the present values of all a project's cash flows, inflows and outflows, at the firm's cost of capital:
NPV = Σ [Cash flow in year t ÷ (1 + k)^t] − Initial outlay
A positive NPV means the project is expected to generate a return exceeding the cost of capital, adding value to the firm and therefore to shareholder wealth, and should be accepted. A negative NPV means the reverse, and the project should be rejected. Among competing, mutually exclusive projects, the one with the higher NPV is preferred, because NPV directly measures the absolute rupee value the project is expected to add.
Internal rate of return (IRR) is the discount rate at which a project's NPV equals exactly zero — the break-even discount rate, in effect, at which the present value of inflows exactly equals the present value of outflows. Since IRR generally cannot be solved for algebraically except in simple cases, it is found by trial and error or interpolation between two discount rates, one giving a positive NPV and one giving a negative NPV, using the formula:
IRR = Lower rate + [NPV at lower rate ÷ (NPV at lower rate − NPV at higher rate)] × (Higher rate − Lower rate)
A project is accepted under the IRR rule if its IRR exceeds the firm's cost of capital, and rejected if it falls short — note that this is the same accept-or-reject conclusion NPV would reach for a single, independent project, since a project earning a return above the cost of capital by definition has a positive NPV at that cost of capital.
Profitability index (PI), also called the benefit-cost ratio, is the present value of future cash inflows divided by the initial outlay:
PI = Present value of cash inflows ÷ Initial outlay
A PI above 1 corresponds to a positive NPV and signals acceptance; a PI below 1 corresponds to a negative NPV and signals rejection. PI's specific value is in ranking projects under capital rationing — where a firm has a fixed budget insufficient to fund every positive-NPV project available — since PI expresses value created per rupee of outlay, letting a firm fund the combination of projects that maximises total NPV from a limited pool of capital, rather than simply picking the single largest-NPV project and leaving the rest of the budget unused.
Why NPV is the theoretically preferred technique
Examiners test this comparison directly, and the reasoning is worth internalising precisely rather than accepting on authority. NPV is preferred over IRR for three specific, statable reasons.
NPV assumes reinvestment of intermediate cash flows at the firm's cost of capital, a realistic, achievable rate, since the cost of capital is genuinely the rate at which the firm can raise or deploy funds. IRR implicitly assumes reinvestment of intermediate cash flows at the project's own IRR, which, for a project with an unusually high IRR, is an unrealistic assumption — the firm is unlikely to find further opportunities to reinvest intermediate cash flows at that same high rate repeatedly.
NPV gives an unambiguous accept-or-reject signal and a clear ranking even when comparing projects of different scale or different cash flow timing, whereas IRR can produce multiple IRRs for a project with unconventional cash flows — for instance, a project with a large cash outflow in a later year, such as environmental remediation cost, in addition to the initial outlay, can produce more than one discount rate at which NPV equals zero, leaving the IRR rule genuinely ambiguous about which rate to compare against the cost of capital.
NPV correctly ranks mutually exclusive projects of different size, since it measures absolute value added in rupees, whereas IRR, being a percentage, can favour a smaller project with a higher percentage return over a larger project that, despite a lower percentage return, adds substantially more absolute value — exactly the kind of conflict a scale problem produces, and one that a firm genuinely seeking to maximise shareholder wealth should resolve in NPV's favour, since wealth maximisation, the objective established at the start of this paper, is measured in absolute rupees of value, not in percentage returns.
Handling conflicting rankings between NPV and IRR
Where NPV and IRR rank two mutually exclusive projects differently — one technique favours Project A, the other favours Project B — the conflict typically arises from either a difference in the scale of initial investment or a difference in the timing pattern of cash flows between the two projects. The resolution is to compute the incremental cash flows between the two projects, that is, the larger project's cash flows minus the smaller project's cash flows year by year, and find the IRR of this incremental cash flow stream. If this incremental IRR exceeds the cost of capital, the additional investment required by the larger project is itself justified, and the larger project, the one NPV favours, should be selected; if the incremental IRR falls short of the cost of capital, the smaller project should be preferred instead. This incremental analysis, in every case, agrees with what NPV directly indicates, which is precisely why NPV, not IRR, is the technique treated as decisive whenever the two genuinely conflict.
How this chapter is examined
Expect either a full NPV computation from raw project data, requiring correct construction of the initial outlay, annual operating cash flows and terminal cash flow before any discounting is applied, or a comparative question asking why NPV is preferred to IRR, or a capital rationing question requiring PI-based ranking. Set out the three cash flow stages as clearly labelled sections in your working, apply the discount factors as a separate row in a tabulated computation rather than embedding them in running prose, and state explicitly which technique's recommendation you are following and why whenever NPV and IRR could plausibly disagree.
