Investment Decisions
This domain tests capital budgeting discipline: which cash flows are relevant, how to discount them, and how to rank projects when capital is limited.
Core rules
- Use incremental after-tax cash flows. Exclude sunk costs and allocated head-office overhead; include opportunity costs, incremental working capital and tax on salvage.
- Depreciation is not a cash flow, but the tax shield is: tax saving = depreciation × tax rate.
- NPV is the decision rule; accept when NPV > 0. IRR can give multiple answers with non-conventional flows and assumes reinvestment at IRR; MIRR fixes the reinvestment rate; discounted payback handles timing but ignores flows after the cut-off.
- Under capital rationing with divisible projects, rank by profitability index (PV of inflows / initial outlay); with indivisible projects, use trial combinations.
- Project risk: either adjust the discount rate (risk-adjusted discount rate) or convert expected cash flows to certainty equivalents and discount at the risk-free rate - never both.
- Real options (defer, expand, abandon, switch) add value beyond static NPV and explain why managers sometimes accept apparently negative-NPV projects.
Worked example
Outlay ₹100 lakh, life 5 years, straight-line depreciation to nil, tax 30%, required return 12%, annual cash savings ₹30 lakh. Depreciation = 20, so PBT = 10, tax = 3, PAT = 7, and CFAT = 7 + 20 = 27 lakh. At 12% for 5 years, the annuity factor is 3.6048, giving PV = 97.33 lakh. NPV = −2.67 lakh, so reject. The IRR is around 11%, below the 12% hurdle - the two methods agree here because flows are conventional, which reassures the examiner that the arithmetic is consistent.
Traps
Discounting nominal cash flows at a real rate; forgetting working-capital recovery at project end; deducting interest when cash flows are already discounted at WACC; and ranking by IRR when project sizes differ.