Capital Budgeting Techniques

Why This Matters

Capital budgeting sits at the heart of corporate finance—it's how firms decide which projects create shareholder value and which destroy it. You're being tested on your ability to not just calculate NPV or IRR, but to understand when each technique works best, where it fails, and how sophisticated practitioners combine multiple methods to make robust investment decisions. Expect exam questions that force you to choose between conflicting signals (what happens when NPV says yes but payback says no?) or identify which technique applies to a specific scenario.

The techniques you'll master here connect directly to core finance principles: time value of money, risk-adjusted returns, opportunity cost, and optionality. Whether you're evaluating a simple equipment purchase or a complex R&D initiative with uncertain outcomes, these tools form your analytical toolkit. Don't just memorize formulas—know what assumptions each method makes, what it ignores, and when to reach for a more sophisticated approach.

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Time Value Methods: The Foundation

These techniques explicitly account for the principle that a dollar today is worth more than a dollar tomorrow. By discounting future cash flows to present value, these methods capture opportunity cost and provide theoretically sound measures of value creation.

Net Present Value (NPV)

• Sum of discounted cash flows minus initial investment—the gold standard for capital budgeting because it directly measures dollar value created
• Positive NPV means the project exceeds the required return; accept all positive-NPV projects in a world without capital constraints
• Assumes reinvestment at the discount rate (typically WACC), which is more realistic than IRR's assumption

Internal Rate of Return (IRR)

• The discount rate that sets NPV equal to zero—essentially the project's breakeven cost of capital expressed as a percentage
• Accept when IRR exceeds the hurdle rate (cost of capital), but beware of ranking conflicts with NPV for mutually exclusive projects
• Fails with non-conventional cash flows—sign changes can produce multiple IRRs or no real solution at all

Modified Internal Rate of Return (MIRR)

• Assumes reinvestment at WACC rather than the IRR itself—solving IRR's unrealistic reinvestment assumption
• Always produces a single, unique rate even with non-conventional cash flows, making it more reliable for comparison
• Calculated by finding the rate that equates terminal value of inflows to present value of outflows—a hybrid approach

Profitability Index (PI)

• Ratio of PV of future cash flows to initial investment—essentially NPV per dollar invested, expressed as $PI = \frac{PV(\text{Cash Flows})}{I_0}$
• PI > 1 indicates positive NPV; the higher the PI, the more value created per capital dollar deployed
• Critical for capital rationing decisions where you must maximize total value from a limited budget

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Speed-Based Methods: Liquidity and Risk Proxies

These techniques focus on how quickly a project returns invested capital. While theoretically inferior to NPV, they capture managerial concerns about liquidity risk and forecast uncertainty that pure DCF methods ignore.

Payback Period

• Time required to recover initial investment from undiscounted cash flows—simple division when cash flows are constant, cumulative counting when they vary
• Ignores time value of money and all cash flows after payback—theoretically flawed but practically useful as a risk screen
• Shorter payback preferred because it reduces exposure to forecast error and improves liquidity

Discounted Payback Period

• Time to recover initial investment using discounted cash flows—addresses payback's TVM problem while retaining its intuitive appeal
• Always longer than simple payback because discounted cash flows are smaller than nominal ones
• Still ignores post-payback cash flows, so a project with massive terminal value could be rejected

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Accounting-Based Methods: Simplicity with Trade-offs

These approaches use accounting profits rather than cash flows. While easier to calculate from financial statements, they sacrifice theoretical rigor by ignoring TVM and conflating accrual accounting with economic value.

Accounting Rate of Return (ARR)

• Average accounting profit divided by average investment—expressed as $ARR = \frac{\text{Average Net Income}}{\text{Average Book Value}}$
• Ignores time value of money and uses profits instead of cash flows—both significant theoretical weaknesses
• Easy to compute from existing financial data, making it useful for preliminary screening despite its limitations

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Project Comparison Methods: Apples to Apples

When projects have different lifespans or scales, direct NPV comparison can mislead. These techniques standardize comparisons to enable fair evaluation of mutually exclusive alternatives.

Equivalent Annual Annuity (EAA)

• Converts NPV into an annual equivalent payment—calculated as $EAA = \frac{NPV \times r}{1 - (1+r)^{-n}}$ where $n$ is project life
• Essential for comparing projects with different lifespans—a 3-year project and 7-year project can't be compared by NPV alone
• Assumes projects can be replicated indefinitely at the same terms, which may not hold in practice

Capital Rationing

• Selecting the optimal project portfolio under budget constraints—not a calculation method but a decision framework
• Rank by PI and select projects until capital is exhausted—this maximizes total NPV given limited funds
• Integer constraints create complexity—sometimes you can't take partial projects, requiring optimization techniques

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Risk Analysis Methods: Beyond Point Estimates

Single-point NPV calculations hide uncertainty. These techniques reveal how sensitive your conclusions are to assumptions and quantify the range of possible outcomes.

Sensitivity Analysis

• Tests how NPV changes when one input variable changes—holding all others constant to isolate individual effects
• Identifies key value drivers by showing which variables (sales volume, price, costs) have the greatest impact
• Produces tornado diagrams ranking variables by influence—essential for focusing management attention

Scenario Analysis

• Evaluates NPV under discrete scenarios—typically best case, base case, and worst case with internally consistent assumptions
• Captures correlation between variables that sensitivity analysis misses (e.g., recession affects both sales and costs)
• Provides range of outcomes but only for the specific scenarios defined—doesn't show full probability distribution

Monte Carlo Simulation

• Generates thousands of NPV outcomes by randomly sampling input distributions—producing a probability distribution of results
• Quantifies probability of negative NPV or failing to meet hurdle rates—powerful for communicating risk to stakeholders
• Requires specifying probability distributions and correlations for all uncertain inputs, which can be challenging

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Advanced Valuation Methods: Capturing Flexibility

Traditional DCF assumes passive management—invest now, receive cash flows later. These techniques value the ability to adapt decisions as uncertainty resolves, capturing strategic flexibility that NPV misses.

Real Options Analysis

• Values managerial flexibility as financial options—option to expand, abandon, delay, or switch embedded in projects
• Uses option pricing models (Black-Scholes, binomial trees) adapted for real assets rather than financial securities
• Most valuable when uncertainty is high and decisions are reversible—R&D, natural resources, and staged investments

Weighted Average Cost of Capital (WACC)

• The blended required return across all capital sources—calculated as $WACC = w_e \cdot r_e + w_d \cdot r_d(1-T)$ where weights reflect target capital structure
• Serves as the discount rate for NPV when project risk matches firm risk—the hurdle rate for investment decisions
• Must be adjusted for project-specific risk—using pure-play betas or subjective adjustments when project differs from firm average

Cash Flow Estimation

• Forecasting incremental, after-tax cash flows—the critical input that determines whether any technique produces meaningful results
• Include opportunity costs, exclude sunk costs and financing flows—common exam traps involve misclassifying these items
• Focus on free cash flow to firm (FCFF)—operating cash flow minus capital expenditures, before interest payments

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Quick Reference Table

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Self-Check Questions

1. When NPV and IRR give conflicting rankings for mutually exclusive projects, which should you follow and why? Under what conditions do these conflicts arise?

2. A firm is evaluating two projects: Project A has a 2-year life with NPV of $50,000, and Project B has a 5-year life with NPV of $100,000. Why is direct NPV comparison misleading, and which technique should you use instead?

3. Compare and contrast sensitivity analysis and Monte Carlo simulation. When would you recommend each approach, and what additional information does Monte Carlo provide?

4. Why does the profitability index become more important than NPV when a firm faces capital rationing? Construct a simple example where the highest-NPV project should be rejected.

5. A biotech company is evaluating an R&D project with highly uncertain outcomes and multiple decision points over 10 years. Why might traditional NPV undervalue this project, and what alternative approach captures the missing value?