Capital Budgeting Methods

Overview

• What you’ll learn: The four primary capital budgeting methods (NPV, IRR, payback period, accounting rate of return), the time value of money, how to evaluate long-term investment decisions, and why NPV is the theoretically superior method.
• Prerequisites: Lesson 3 — Inventory Management & JIT
• Estimated reading time: 18 minutes

Introduction

The Grand Historian records: The emperor who builds a canal spends a fortune today to reap harvests for a century. The emperor who builds a palace spends a fortune today to house parties for a decade. Both are capital investments; only one generates economic return. Capital budgeting is the discipline of evaluating these long-term commitments — the decisions that shape the enterprise for years or decades, that cannot be easily reversed, and that consume vast resources. Getting them right is essential; getting them wrong is often fatal.

Horngren (Chapter 21) presents four methods for evaluating capital investments. Two use discounted cash flows (DCF) and are theoretically superior; two do not and serve as supplementary tools.

The Time Value of Money

A dollar today is worth more than a dollar tomorrow because today’s dollar can be invested to earn a return. This fundamental principle underlies all DCF methods:

Present Value = Future Cash Flow / (1 + r)^n

Where r = discount rate (required rate of return) and n = number of periods.

Method 1: Net Present Value (NPV)

NPV = Sum of PV of all future cash inflows − Initial investment

Decision rule: Accept if NPV > 0; reject if NPV < 0. A positive NPV means the investment earns more than the required rate of return — it creates value for shareholders.

Example

NPV is positive — the project earns more than the 10% required return and should be accepted.

Method 2: Internal Rate of Return (IRR)

IRR is the discount rate that makes NPV equal to zero — the project’s “break-even” rate of return.

Decision rule: Accept if IRR > required rate of return (hurdle rate); reject if IRR < hurdle rate.

Limitations of IRR:

• Multiple IRRs can exist for projects with non-conventional cash flows (alternating inflows and outflows).
• IRR assumes reinvestment of intermediate cash flows at the IRR itself — which may be unrealistic.
• IRR can rank projects differently than NPV when comparing mutually exclusive alternatives of different sizes or durations.

太史公曰：When NPV and IRR disagree, trust NPV. It measures absolute wealth creation; IRR measures only the rate. A small project with a high IRR may create less value than a large project with a lower IRR but higher NPV.

Method 3: Payback Period

Payback Period = Time required to recover the initial investment from cash inflows

Strengths: Simple, intuitive, measures liquidity risk. Limitations: Ignores the time value of money, ignores cash flows after payback, and does not measure profitability. The discounted payback period partially addresses the first limitation.

Method 4: Accounting Rate of Return (ARR)

ARR = Average annual accounting income / Average investment

Based on accrual accounting numbers, not cash flows. Easy to compute but theoretically weakest — it ignores the time value of money and uses income (which includes non-cash items like depreciation) rather than cash flows.

Choosing Among Methods

Key Takeaways

• NPV is the theoretically superior method — it measures absolute value creation using discounted cash flows.
• IRR is the discount rate that makes NPV = 0; useful for communication but can mislead when comparing projects.
• Payback period measures liquidity but ignores time value and post-payback cash flows.
• When NPV and IRR conflict, trust NPV.
• In practice, most companies use multiple methods — NPV for the decision, payback for risk screening, IRR for communication.

What’s Next

In Lesson 5, we tackle advanced capital budgeting topics — inflation, income taxes, real options, and sensitivity analysis for investment decisions.