Capital Budgeting (NPV & IRR)
Capital budgeting is the process of evaluating long-term investment projects using techniques such as net present value (NPV), internal rate of return (IRR), and payback period.
Explanation
NPV discounts all expected future cash flows at the required rate of return and subtracts the initial investment — a positive NPV means the project adds value. IRR is the discount rate that makes NPV equal to zero; projects are accepted if IRR exceeds the hurdle rate. The payback period measures how quickly the initial investment is recovered but ignores time value of money. Profitability index (NPV of inflows ÷ initial investment) helps rank mutually exclusive projects. All methods should use after-tax incremental cash flows.
Key Points
- •NPV > 0: accept the project; NPV < 0: reject
- •IRR = discount rate where NPV equals zero
- •Use after-tax incremental cash flows, not accounting income
Exam Tip
When NPV and IRR conflict for mutually exclusive projects, NPV is the preferred method because it measures absolute value added.
Frequently Asked Questions
Related Topics
Financial Ratio Analysis
Financial ratio analysis evaluates a company's performance, liquidity, solvency, and efficiency by computing and comparing ratios derived from financial statement data.
Relevant Costs and Decision-Making
Relevant costs are future costs that differ between decision alternatives; sunk costs and costs that do not change between options are irrelevant to the decision.
Test your knowledge
Practice scenario-based questions on this topic with detailed explanations.