Capital Budgeting Techniques: NPV, IRR & Payback Period

Imagine you are the CEO of a company. You have ₹10 Crores in the bank. You can either buy a new factory, acquire a competitor, or launch a new product line. Where do you put the money?

This decision is what we call Capital Budgeting . It is arguably the most critical job of a financial manager. One wrong move here can bankrupt a company, while a right move can create decades of profit. Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owner wealth.

The Golden Rule: An investment is only worth making if it generates more cash than it costs, after accounting for the value of time.

1. The Big Three Techniques

While there are many ways to evaluate a project, three techniques dominate the financial world. We will rank them from "Basic" to "The Gold Standard":

• Payback Period: How fast do I get my money back? (Simple, but flawed).
• Internal Rate of Return (IRR): What is the percentage return on this project? (Popular, but can be tricky).
• Net Present Value (NPV): How much actual value (wealth) does this create today? (The absolute best method).

---

2. Net Present Value (NPV): The Gold Standard

NPV is the difference between the Present Value (PV) of cash inflows and the Present Value of cash outflows. It tells you exactly how much richer the company becomes *today* if it takes the project.

The Logic

Remember Time Value of Money (TVM) ? A rupee tomorrow is worth less than a rupee today. NPV discounts all future cash flows back to today's value using a specific Discount Rate (often the cost of capital).

The Formula

Example Calculation

Project A: Costs ₹1,00,000 today. Returns ₹1,20,000 after exactly one year. The discount rate (cost of borrowing money) is 10%.

1. Step 1: Find PV of Inflows.
   ₹1,20,000 / (1 + 0.10)^1 = ₹1,09,090.
2. Step 2: Subtract Initial Cost.
   ₹1,09,090 - ₹1,00,000 = ₹9,090 .

Result: The NPV is +₹9,090 . This means taking this project is mathematically equivalent to someone handing you ₹9,090 cash today. Decision: Accept.

The Decision Rule

• ✓ NPV > 0: Accept the project (Adds value).
• ✕ NPV < 0: Reject the project (Destroys value).
• = NPV = 0: Indifferent (Breaks even).

---

3. Internal Rate of Return (IRR)

While NPV gives a dollar/rupee value, business leaders often prefer percentages. They ask, "What's the ROI?". This is where IRR comes in.

Definition: IRR is the discount rate that makes the NPV of a project exactly zero. It represents the break-even interest rate. If your cost of capital is less than the IRR, you make money.

Example Logic

Using the same Project A above (Invest ₹1L, Get ₹1.2L in 1 year). What interest rate turns ₹1L into ₹1.2L? The answer is 20% .

If your bank loan costs 10% interest, and the project generates 20% (IRR), you have a profit spread. Decision: Accept.

NPV vs. IRR: The Conflict

Usually, both methods agree. But sometimes they conflict, especially when comparing two projects of different sizes.

---

4. Payback Period

This is the simplest method, often used by small business owners. It asks: "How long until I get my initial investment back?"

Example

Investment: ₹5,00,000.
Cash Flows: ₹1L in Year 1, ₹2L in Year 2, ₹2L in Year 3.

Calculation:
Year 1: Recovered ₹1L (Balance ₹4L)
Year 2: Recovered ₹2L (Balance ₹2L)
Year 3: Recovered ₹2L (Balance ₹0)
Payback Period = 3 Years.

Why it is Flawed

• Ignores TVM: It treats ₹1 received in Year 3 as equal to ₹1 paid today. This is financially incorrect.
• Ignores Cash Flows After Payback: If a project pays nothing for 3 years but gives ₹100 Crores in Year 4, Payback method might reject it, while NPV would love it.

However, it is useful as a measure of liquidity risk . Startups with tight cash prefer short payback periods.

5. Summary Comparison