Capital Budgeting (NPV, IRR, Payback)

Capital budgeting is the process of deciding which long-term investments a company should make. Should we build a new plant? Acquire a competitor? Launch a new product line? These decisions commit large sums of capital for years, and getting them wrong is expensive and hard to reverse.

The right framework asks: does this investment earn more than its cost of capital? If yes, it creates value for shareholders. If no, it destroys value, even if it shows an accounting profit, because the returns don't compensate for the risk taken.

In India, capital allocation decisions are especially important because promoter-controlled companies sometimes pursue empire-building projects or related-party acquisitions that serve the promoter's interests rather than minority shareholders'. Good capital budgeting discipline is a governance signal.

Three main techniques:

1. Net Present Value (NPV) NPV = Σ [FCFt ÷ (1 + WACC)^t] − Initial Investment If NPV > 0: accept. If NPV < 0: reject. NPV gives an absolute rupee value created.

2. Internal Rate of Return (IRR) The discount rate at which NPV = 0. Accept if IRR > WACC (hurdle rate). Problem: IRR assumes interim cash flows are reinvested at IRR itself, which is often unrealistic.

3. Payback Period How many years to recover the initial investment. Simple but ignores time value and cash flows beyond payback. Discounted Payback Period corrects for time value.

Using incremental cash flows (always):

• Include: incremental revenue, cost savings, tax effects, changes in working capital, salvage value
• Exclude: sunk costs (already spent, irrelevant), allocated overheads (not incremental)

Example: ₹100 Cr investment, FCF of ₹25 Cr/year for 6 years, WACC 12%. NPV = 25 × [1−(1.12)^-6]/0.12 − 100 = 25 × 4.111 − 100 = ₹2.8 Cr → Marginally positive; proceed but low margin of safety.