Finance I - Lesson 7: Investment Decision Criteria and Capital Budgeting Basics

Capital budgeting refers to the process by which firms evaluate potential long-term investments, such as new products, facilities, or expansions. Sound capital budgeting ensures that resources are allocated to projects with the highest value creation potential, aligning decisions with shareholders’ best interests. This lesson introduces key metrics and criteria used to decide whether to accept or reject proposed investments.

Net Present Value (NPV)

NPV is regarded as the most reliable capital budgeting criterion. It discounts all future cash inflows and outflows back to the present using an appropriate discount rate (often the firm’s cost of capital). Mathematically:

NPV = Σ_{t=0 to n} [CF_t ÷ (1 + r)^t]

If NPV > 0, the project is expected to add value to the firm; if NPV < 0, it typically destroys value. Thus, a positive NPV investment should be accepted, while a negative one should be rejected.

Internal Rate of Return (IRR)

IRR is the discount rate that sets a project’s NPV to zero. Projects with an IRR above the firm’s required return (or cost of capital) may be accepted, as they should theoretically create value. However, IRR can be misleading when projects have non-conventional cash flows (e.g., multiple sign changes) or when comparing mutually exclusive projects with differing scales or durations.

Payback Period

The payback period measures how long it takes to recover the initial investment from a project’s cash flows. Managers might set a cutoff (e.g., 3 years) and accept projects that recoup costs faster. While simple to compute, the payback period ignores cash flows beyond the cutoff and does not account for the time value of money, making it a less robust measure compared to NPV or IRR.

Mermaid Overview of Decision Flow

flowchart TB A(Start Evaluation) --> B{Calculate NPV} B -->|NPV > 0| C[Accept Project] B -->|NPV < 0| D[Reject Project] B -->|NPV = 0| E[Indifferent] E --> F{Check IRR & Other Criteria} F -->|IRR > Required Return| C F -->|IRR < Required Return| D

This simplified flowchart highlights how NPV typically dominates the decision. If the project’s NPV is borderline, firms may consult IRR, payback, or other strategic considerations before deciding.

Examples of Decision Criteria

Illustrative Comparison of Projects

Below is a hypothetical example of three projects with different cash flow patterns. NPV is often preferred, but IRR and payback might add useful context.

All three have positive NPVs, so each could theoretically add value. Beta’s IRR is highest, but it recovers the investment slightly slower than Alpha. Depending on risk tolerance and other strategic considerations, management might choose Beta for its greater return potential or Alpha for quicker payback.

Summary

Capital budgeting decisions significantly impact a firm’s long-term trajectory. By rigorously applying NPV, IRR, and other metrics such as payback period, managers can allocate resources more effectively, maximizing firm value. While NPV remains the most direct indicator of value creation, IRR provides an intuitive “interest rate” viewpoint, and payback emphasizes liquidity and risk mitigation. Understanding these tools empowers companies to navigate investment choices confidently, laying the groundwork for more advanced topics like adjusting for risk, capital rationing, and project interdependencies.

Suggested Reading:
Principles of Corporate Finance by Brealey, Myers, and Allen (chapters on capital budgeting criteria and project evaluation).