BFF2140 Chap.3 Capital Budgeting Methods
Capital Budgeting Methods
Capital Budgeting Methods compare long-lived investments using NPV, IRR, payback and profitability index. NPV remains the primary value rule because it uses all incremental cash flows, recognises their timing and applies an opportunity cost of capital. The other methods can communicate speed or efficiency, but their limitations matter when rankings conflict.
NPV expresses expected value creation in dollars, so a positive result supports acceptance when the discount rate reflects project risk. IRR expresses the break-even discount rate, but unconventional sign changes may produce several rates and mutually exclusive projects can conflict because of scale or timing.
Payback shows how quickly the initial outlay is recovered, yet simple payback ignores discounting and all cash flows beyond its cutoff. Profitability index ranks present value per investment dollar and can help when funding is genuinely scarce, although the feasible package with the greatest total NPV remains the value objective.
NPV profiles make ranking conflicts visible by showing how each project's value changes with the required return. The decision process therefore begins with correct cash-flow signs and dates, then calculates the relevant measures and finishes by explaining which rule answers the economic question. A percentage return, fast recovery or high ratio should not displace the method that measures total value added.
What this chapter covers
- 01
Net present value
- 02
Internal rate of return
- 03
Payback period
- 04
Profitability index
- 05
Mutually exclusive projects
- 06
Capital rationing
- 07
Ranking conflicts caused by project scale, cash-flow timing, nonconventional signs and the difference between percentage return and value added
Worked example · free
Calculate NPV and payback
- 4Discount all four inflows and subtract the time 0 cost to obtain NPV of $21,531.32.
- 3After two years $117,000 is recovered; the remaining $63,000 is 0.875 of year 3's $72,000, so payback is 2.875 years.
Key terms
- Internal return
- The discount rate that makes project NPV equal zero.
- Payback period
- The time required for undiscounted inflows to recover the initial outlay.
- Profitability index
- The present value of future inflows divided by the initial investment.
Capital Budgeting Methods FAQ
Why is NPV preferred?
NPV measures expected dollar value added using all incremental cash flows and their timing. It also applies a required return suited to risk, so its accept or reject rule aligns directly with value creation.
Why can IRR and NPV disagree?
They can disagree for mutually exclusive projects with different scale or timing, and unconventional cash flows can create multiple IRRs. In those cases NPV at the appropriate opportunity cost should guide the decision.
When is profitability index useful?
Profitability index helps allocate a limited capital budget by showing present value per dollar invested. It can still mis-rank mutually exclusive projects when total value rather than value per dollar is decisive.
Exam move
Use one project cash-flow row to compare every appraisal method so their different questions become visible. Put the initial outlay at time 0 with a negative sign, discount each later flow at the opportunity cost and calculate NPV without rounding intermediate present values. State the decision immediately: a positive NPV adds value and is accepted when the cash-flow and risk assumptions are credible.
Next calculate simple payback from cumulative undiscounted flows and identify the exact fraction of the recovery year. Explain that payback measures recovery speed but ignores time value and cash flows beyond its cutoff. Find IRR as the rate that sets NPV to zero, then test whether the cash-flow pattern is conventional.
Changes of sign can create multiple rates or no useful rate, while mutually exclusive projects can be ranked differently because of scale and timing. Plot or imagine the NPV profile to understand the crossover rate rather than treating disagreement as a calculator failure.
Calculate profitability index as present value of future benefits per dollar of initial investment and reserve it for genuine capital rationing, where efficiency of scarce funds matters. Even there, compare the total NPV of feasible project packages because the individually highest index need not create the most total value.
Practise questions that change only the discount rate so you can describe why long-dated projects are more sensitive. For mutually exclusive choices, use incremental cash flows or compare NPVs directly at the relevant required return. Keep a method table with columns for information used, time-value treatment, decision rule and main weakness.
After solving, add a two-sentence recommendation that names both the preferred rule and any constraint affecting implementation. Review mistakes by classifying them as sign, timing, rate, ranking or rule-selection errors. Redo the calculation with a different initial scale to see whether the conclusion survives.
A strong exam response makes clear that an attractive percentage return does not necessarily beat a larger project that creates more dollars of value, and that rapid recovery is not the same objective as shareholder-value maximisation.
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