Investment Appraisal and Capital Budgeting
Domain focus
Investment appraisal evaluates long-term projects using cash flows and the time value of money. The exam tests NPV, IRR, payback, discounted payback, ARR and ranking of mutually exclusive projects.
Core rules
- Use incremental after-tax cash flows. Accounting profit is not cash flow; depreciation is added back, and tax savings from depreciation may be relevant.
- NPV discounts cash flows at the cost of capital; accept positive NPV and reject negative NPV.
- IRR is the discount rate giving zero NPV; accept if IRR exceeds the cost of capital.
- Payback ignores cash flows after payback and the time value of money; discounted payback fixes only the latter.
- ARR uses accounting profit and average investment; it ignores the timing of cash flows.
Worked example
A project costs ₹100,000 and yields ₹30,000 cash inflow annually for five years. Cost of capital is 10%. The five-year annuity factor at 10% is 3.791, so present value = ₹30,000 × 3.791 = ₹113,730. NPV = ₹113,730 - ₹100,000 = ₹13,730 positive, so accept. If projects are mutually exclusive, choose the higher positive NPV, not necessarily the higher IRR.
Traps
Discounting profit instead of cash flow; omitting working capital recovery; including sunk costs; using IRR ranking for mutually exclusive projects; forgetting tax and depreciation tax shields; using ARR as if it were NPV.