Capital Budgeting and Investment Decisions - Study Guide
This domain tests whether a long-term project should be accepted. Expect NPV, IRR, payback, discounted payback and profitability index, plus treatment of incremental cash flows, depreciation, working capital and salvage value.
Core ideas
- Use incremental after-tax cash flows, not accounting profit.
- Ignore sunk costs; include opportunity costs and working-capital changes; recover working capital at project end.
- Depreciation is non-cash but creates a tax shield = depreciation × tax rate.
- NPV = PV of inflows − initial outlay. Accept if NPV > 0.
- IRR is the discount rate making NPV zero; accept if IRR > cost of capital. For mutually exclusive projects, prefer NPV.
- Payback ignores time value and cash flows after payback; use it as a risk screen, not the sole rule.
Worked example
A machine costs ₹1,00,000 and yields ₹30,000 per year for five years. Cost of capital is 10%. The present value annuity factor for 5 years at 10% is 3.7908. PV of inflows = 30,000 × 3.7908 = ₹1,13,724. NPV = 1,13,724 − 1,00,000 = ₹13,724. Since NPV is positive, accept the project. The reasoning: the project earns more than the 10% required return after recovering its cost.
Traps
Do not include interest payments in project cash flows when the discount rate already reflects financing. Do not ignore working capital. Do not choose a project by highest IRR when projects differ in size or life. Payback is not a measure of profitability.