Capital Planning and Investment Analysis
This domain tests whether you can rank competing investments on cash flows, risk, and strategy, and defend the choice when capital is rationed.
Decision rules
NPV discounts all incremental cash flows at the hurdle rate - typically WACC plus a project-risk premium - and is preferred because it measures value added in dollars. IRR is the discount rate at which NPV equals zero; it agrees with NPV for conventional cash flows but misleads when projects differ in scale or timing, or when cash flows change sign more than once. Payback and discounted payback measure liquidity and risk exposure, not value. Profitability index (PV of inflows ÷ initial outlay) ranks projects under a fixed capital budget. Include working capital, terminal value, and tax effects for for-profit entities, and always use cash flows rather than accounting income.
Risk and strategy
Risk-adjust the hurdle rate by project class: replacement at the base rate, growth and new ventures higher. Test the two or three assumptions that dominate - volume, reimbursement, construction cost - with sensitivity and scenario analysis. Strategic projects may justify a lower standalone NPV when they protect a service line or market position, but the strategic value should be documented rather than used to excuse a weak business case.
Worked example
A $1,000,000 equipment purchase generates $300,000 of net cash flow for five years at an 8% hurdle rate. PV of inflows = 300,000 × 3.9927 = $1,197,810; NPV = $197,810; profitability index = 1.20; payback = 3.33 years; IRR ≈ 15.2% (the annuity factor 3.3333 falls between the 15% and 16% factors). The project clears the hurdle with room to spare. If capital is capped at $1M and a competing project has an index of 1.35, that project ranks first despite a possibly lower absolute NPV.
Traps
- Choosing the higher IRR over the higher-NPV project when the projects differ in scale.
- Treating depreciation as a cash outflow in the NPV calculation.
- Ignoring installation, downtime, and training costs in the initial outlay.
- Comparing projects with different lives without an equivalent annual annuity.