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capital budgetingintermediate25 min
Capital Budgeting Decision Framework
A structured approach to evaluating investment projects using NPV, IRR, payback, and profitability index.
What You'll Learn
- ✓Identify relevant cash flows
- ✓Apply multiple evaluation metrics
- ✓Make consistent accept/reject decisions
1. Identify Incremental Cash Flows
Only include cash flows that change because of the project. Ignore sunk costs. Include opportunity costs and side effects.
Key Points
- •Sunk costs are irrelevant
- •Opportunity costs are relevant
- •Include cannibalization effects on existing products
2. Apply NPV as Primary Rule
Discount all incremental cash flows at the appropriate rate. Positive NPV creates shareholder value.
Key Points
- •NPV handles scale and timing correctly
- •Use WACC for average-risk projects
- •Adjust for project-specific risk when needed
3. Check IRR and Payback
Use IRR for intuition and communication. Use payback for liquidity screening. Neither replaces NPV.
Key Points
- •IRR can mislead with non-conventional cash flows
- •Payback ignores time value and post-cutoff flows
- •All three metrics should align for a clear decision
4. Rank Under Constraints
When capital is limited, use profitability index to maximize value per dollar invested.
Key Points
- •PI = PV of cash flows / initial investment
- •Rank by PI, select top projects within budget
- •Check if the combination is feasible
Key Takeaways
- ★Working capital investment at start must be recovered at end
- ★Tax depreciation creates a cash flow (tax shield)
- ★Terminal value in project analysis differs from DCF terminal value
Practice Questions
1. A factory was purchased last year for $1M to evaluate this project. Is the $1M relevant?
No. It is a sunk cost and should not affect the project decision.
2. Project NPV = $50K, IRR = 8%, hurdle = 10%. Accept or reject?
Reject. Although NPV seems positive, recheck—IRR < hurdle usually means NPV should be negative. There may be a calculation error.
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FAQs
Common questions about this topic
With mutually exclusive projects of different scale or timing. Always defer to NPV.
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