Capital Budgeting

The three workhorse techniques are NPV, IRR, and payback period. NPV discounts all project cash flows to today and subtracts the upfront cost; a positive NPV means the project creates value above the hurdle rate. IRR is the discount rate that makes NPV zero — you accept the project if IRR exceeds the hurdle. Payback period measures how long until the project recovers its initial outlay. NPV is theoretically superior because it measures absolute dollar value created and assumes reinvestment at the hurdle rate, whereas IRR assumes reinvestment at the IRR itself.

For independent projects (you can do all that clear the bar), NPV and IRR usually agree. The conflict arises with mutually exclusive projects — when you can only pick one. IRR is a percentage and ignores scale: a $1M project with a 40% IRR creates less absolute value than a $50M project with a 20% IRR. NPV captures the dollar magnitude, so when the two methods disagree, defer to NPV. IRR can also produce multiple or no solutions when cash flows switch signs more than once (non-conventional cash flows), another reason bankers anchor decisions on NPV.

Good capital budgeting lives or dies on the quality of the cash flow forecast. Analysts project incremental free cash flow — revenue minus operating costs and taxes, plus depreciation add-back, minus CapEx and changes in working capital. Two disciplines matter most: ignore sunk costs (money already spent is irrelevant) and include only incremental effects (cannibalization of existing products counts as a cost). A terminal or salvage value is added in the final year to capture the project's worth beyond the explicit forecast.