Capital Budgeting

Section: Capital Budgeting Estimated study time: 45 minutes Content: Capital budgeting is the process by which companies evaluate and select long-term investment projects — decisions to invest in new equipment, expand capacity, launch new products, or make acquisitions. These decisions are critical because capital is scarce and mistakes are difficult to reverse. The fundamental principle of capital budgeting is that a project should be accepted if it increases shareholder value — operationally, if its return exceeds the required rate of return (cost of capital). The four primary capital budgeting decision rules are: Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Discounted Payback Period. NPV and IRR are the theoretically sound methods; payback period is widely used in practice despite being theoretically inferior. Net Present Value (NPV) is the sum of the present values of all cash flows associated with the project, discounted at the firm's cost of capital (hurdle rate): NPV = Σ [CFt / (1 + r)^t] – Initial Investment. If NPV > 0, the project creates value for shareholders and should be accepted. If NPV < 0, the project destroys value and should be rejected. For mutually exclusive projects (where only one can be chosen), the project with the higher NPV should be selected. NPV assumes that interim cash flows are reinvested at the cost of capital, which is a realistic assumption for most firms. The Internal Rate of Return (IRR) is the discount rate that makes NPV = 0. Mathematically, it is the root of the NPV equation: 0 = Σ [CFt / (1 + IRR)^t] – Initial Investment. The decision rule is: accept the project if IRR > required rate of…