Investment Decisions
What you must know
Capital budgeting dominates this domain. Master net present value (NPV), internal rate of return (IRR), payback and discounted payback, profitability index, and modified IRR. NPV is preferred because it measures value added in dollars and handles changing discount rates and scale differences. Build incremental after-tax cash flows: initial outlay (equipment plus installation plus net working capital, less after-tax proceeds from any asset replaced), operating cash flows (typically (revenues − cash expenses) × (1 − t) + depreciation × t), and terminal cash flow (salvage net of tax plus working capital recovery). The depreciation tax shield equals depreciation × tax rate; a gain on salvage is taxed, a loss yields a tax benefit.
Traps that show up
- Deducting interest expense in the cash flows while also discounting at the WACC-double counting the cost of financing.
- Including sunk costs (already-spent research) or allocated overhead that does not change.
- Forgetting working capital investment at the start and its recovery at the end.
- Choosing IRR over NPV for mutually exclusive projects: IRR can mislead when scale or timing differs.
- Ignoring the tax effect on salvage value.
- Under capital rationing, ranking by IRR instead of profitability index when funds are limited.
Worked example
A machine costs $100,000, has no salvage, and generates $30,000 of after-tax operating cash flow for five years. At 10%, the annuity factor is 3.7908, so PV = $113,724 and NPV = $13,724. Accept. If funds are rationed and another project has a higher profitability index (PV of inflows ÷ initial outlay), that project takes priority.
Rule of thumb
If NPV is positive at the risk-adjusted cost of capital, the project creates value-then check the profitability index only when capital is constrained.