Investment Decisions - Capital Budgeting
Capital budgeting evaluates long-term projects using incremental after-tax cash flows. The exam tests method selection, cash-flow timing, tax depreciation and conflict between NPV and IRR.
Core methods
- NPV = PV of cash inflows − initial outlay; accept if NPV > 0.
- IRR is the discount rate giving NPV = 0; accept if IRR > cost of capital.
- Payback and discounted payback measure liquidity, not value.
- Profitability index = PV inflows/initial outlay; useful under capital rationing.
- ARR uses accounting profit and ignores time value.
Worked example
A machine costs ₹100 lakh, yields ₹40 lakh annually for four years, and the cost of capital is 10%. PVAF(10%,4) = 3.170, so PV = ₹126.8 lakh and NPV = ₹26.8 lakh. PI = 1.268. Payback = 100/40 = 2.5 years. IRR solves 40×PVAF(r,4) = 100; PVAF = 2.500, giving IRR approximately 21.9%. All value-based signals accept the project. If a competing project had a higher IRR but smaller NPV, NPV would be preferred for absolute wealth.
Traps
Exclude sunk costs and financing flows; include opportunity costs and working-capital recovery; depreciate for tax, not for cash flow; match nominal rates to nominal cash flows; and do not rank mutually exclusive projects by IRR alone.