Capital Budgeting Techniques: PBP, ARR, NPV, IRR & Profitability Index

Explanation

Capital budgeting decisions are irreversible strategic commitments. Because cash flows occur over multiple operating years, discounted cash flow (DCF) techniques (NPV and IRR) adjust for time preference and project risk. A positive NPV directly measures the net addition to total shareholder wealth.

Key points

• Cash Flows (CFAT = EAT + Depreciation) are used instead of accounting profits.
• Payback Period (PBP): Time required to recover initial investment. (Non-discounted).
• Net Present Value (NPV): NPV = ∑ [CFAT_t / (1 + k)^t] - Initial Outlay. Accept project if NPV > 0.
• Internal Rate of Return (IRR): Discount rate that makes NPV = 0. Accept if IRR > Cost of Capital (k).
• Profitability Index (PI): PI = PV of Cash Inflows / Initial Outlay. Accept if PI > 1.0.
• NPV vs IRR Conflict: Can occur in mutually exclusive projects due to scale differences or reinvestment rate assumptions (NPV assumes reinvestment at cost of capital k; IRR assumes reinvestment at IRR). NPV is theoretically superior.

Example

Code examples

// Worked Capital Budgeting Problem:
// Project Outlay: NPR 100,000; Cost of Capital k = 10%
// Cash Inflows: Year 1: 40k, Year 2: 40k, Year 3: 30k, Year 4: 20k
//
// Year | CFAT    | PVIF(10%) | Present Value
// -----+---------+-----------+--------------
//   1  | 40,000  |  0.9091   |   36,364
//   2  | 40,000  |  0.8264   |   33,056
//   3  | 30,000  |  0.7513   |   22,539
//   4  | 20,000  |  0.6830   |   13,660
// Total PV of Inflows = NPR 105,619
// Net Present Value (NPV) = 105,619 - 100,000 = +NPR 5,619 (ACCEPT PROJECT!)
// Profitability Index (PI) = 105,619 / 100,000 = 1.056

Exam questions

• [8 Marks] A project costs NPR 200,000 and generates cash flows: Y1: 60k, Y2: 80k, Y3: 70k, Y4: 50k. Calculate: (i) PBP, (ii) NPV at 10%, (iii) PI, (iv) IRR.
• [7 Marks] Explain why NPV and IRR methods can give conflicting rankings for mutually exclusive projects. Which method is preferred and why?