Capital Budgeting
Master NPV, IRR, payback, and project cash-flow setup. Capital budgeting helps firms decide which long-term investments create value. Getting the cash flow identification right is often harder than the math itself, since you must separate incremental project effects from sunk costs and existing operations.
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Study Tips
- ✓Separate operating vs financing cash flows
- ✓Check terminal value assumptions
- ✓Use NPV as primary decision rule
- ✓Always include opportunity cost
Common Mistakes to Avoid
Including sunk costs and forgetting working-capital recovery at end of project life. Also watch for students who use IRR to rank mutually exclusive projects when NPV and IRR give conflicting rankings.
Capital Budgeting FAQs
Common questions about capital budgeting
In class and in practice, NPV is usually the primary metric because it measures dollar value created. IRR is useful for communicating returns but can mislead with non-conventional cash flows or mutually exclusive projects.
Projects where accepting one means rejecting the other. Use NPV to compare, not IRR, because NPV correctly accounts for differences in scale and timing of cash flows.
Sunk costs have already been spent and cannot be recovered regardless of the decision. Only future incremental cash flows matter because they are the ones affected by the accept/reject choice.
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