Capital Budgeting Basics: Project Evaluation, Payback, NPV and IRR (Intro Level)

Overview

Capital budgeting is the process of deciding whether to invest money in long-term projects (machinery, expansion, new product, etc.). These decisions matter because they involve large cash outflows now and cash inflows over many years. Therefore, we evaluate projects using cash flows and methods like payback period, NPV, and IRR.

Learning objectives

You should be able to:

• Define capital budgeting and explain its importance.
• Distinguish cash flow from accounting profit.
• Explain steps in project evaluation.
• Compute and interpret payback period (simple).
• Explain NPV and IRR and state decision rules.
• Compare NPV and IRR using a table.

Meaning of capital budgeting

Capital budgeting is the process of planning and evaluating long-term investments to decide whether they should be accepted or rejected based on expected cash flows and risk (concept).

Why capital budgeting is important

Importance (write any 5):

• involves large investment and long-term commitment
• affects profitability and company value
• projects are difficult to reverse once started (irreversibility) (concept)
• involves risk and uncertainty in future cash flows
• impacts competitive position and growth (concept)

Cash flows vs accounting profit (table)

Key exam line: Capital budgeting uses cash flows, not accounting profit.

Steps in project evaluation (flow)

Identify project → Estimate cash outflows/inflows → Choose appraisal method (payback/NPV/IRR) → Apply decision rule → Select project → Implement and review (concept)

Payback period: meaning and computation

Payback period is the time required to recover the initial investment from the project’s cash inflows.

Decision rule (simple):

• accept if payback is less than a target period (set by firm) (concept)

Computation:

• if equal inflows each year: Payback = Initial investment / Annual cash inflow
• if unequal inflows: add yearly inflows until initial investment is recovered (concept)

Payback example (simple)

Initial investment = ₹100,000
Annual inflow = ₹25,000 (each year)

Payback = 100,000 / 25,000 = 4 years.

Interpretation: investment is recovered in 4 years (after that, inflows are surplus).

NPV: meaning and decision rule

NPV (Net Present Value) is the difference between present value of cash inflows and present value of cash outflows, discounted at the required rate (cost of capital) (concept).

Decision rule:

• NPV > 0: accept
• NPV = 0: indifferent
• NPV < 0: reject

NPV example (simple)

Initial outflow = ₹1,000
Inflow after 1 year = ₹1,200
Discount rate = 10%

PV of inflow = 1,200 / 1.10 = ₹1,090.91 (approx.)
NPV = 1,090.91 − 1,000 = ₹90.91 (positive) → accept (concept).

IRR: meaning and decision rule

IRR (Internal Rate of Return) is the discount rate at which NPV becomes zero (PV of inflows = PV of outflows) (concept).

Decision rule:

• accept if IRR > required rate (cost of capital) (concept)

IRR is often found by trial-and-error or financial calculator/spreadsheet (concept).

NPV vs IRR (table)

Advantages and limitations (quick list)

Payback:

• Advantages: simple, focuses on liquidity
• Limitations: ignores TVM and later cash flows (concept)

NPV:

• Advantages: considers TVM, measures value addition
• Limitations: depends on discount rate assumption (concept)

IRR:

• Advantages: percentage measure, considers TVM
• Limitations: may give multiple IRRs in unusual cash flows (concept)

Quick recap (1-minute revision)

• Capital budgeting evaluates long-term projects using cash flows.
• Payback = time to recover investment; simple but ignores TVM.
• NPV = PV(inflows) − PV(outflows); accept if NPV > 0.
• IRR = rate where NPV = 0; accept if IRR > required rate.
• NPV gives value in money; IRR gives percentage return.