This lesson covers the core techniques for evaluating long-term investment projects, known as capital budgeting. It examines the net present value (NPV) method, the internal rate of return (IRR), the payback period, and the accounting rate of return (ARR), as detailed in the CFA Institute’s Corporate Finance study session, the ICAEW syllabus, and Munster Technological University’s module .

 

  • The Capital Budgeting Process: Capital budgeting is the process of analysing and deciding which long-term investments a company should pursue. The ICAEW syllabus identifies investment appraisal as a core topic, including “Cost/benefit analysis, Relevant costs and cash flows, The time value of money” . The CFA Corporate Finance study session covers the “Capital Budgeting Process” and “Basic Principles of Capital Budgeting” as core topics .

  • Net Present Value (NPV): The NPV method calculates the present value of all future cash flows from a project, discounted at the firm’s cost of capital, and subtracts the initial investment. A positive NPV indicates that the project will increase shareholder wealth. The CFA study session identifies NPV as a core investment decision criterion .

  • Internal Rate of Return (IRR): The IRR is the discount rate that results in a net present value of zero. A project is accepted if its IRR is greater than the required rate of return. The CFA study session covers IRR and ranking conflicts between NPV and IRR . Munster Technological University’s syllabus includes “Discounting techniques” and “Calculations using Payback, Net Present Value, Accounting rate of return and Internal rate of return” .

  • Payback Period: The payback period is the time required to recover the initial investment. It is simple to calculate but ignores the time value of money and cash flows beyond the payback period. The CFA study session covers the payback period and discounted payback period .

  • Accounting Rate of Return (ARR): The ARR is the average annual accounting profit divided by the average investment. It uses accounting profits rather than cash flows and ignores the time value of money. The ICAEW syllabus identifies “Profit/accounting driven vs. cash driven measures, including accounting driven, accounting rate of return (ARR), payback, cash driven, net present value (NPV)” .

  • Comparison and Ranking Conflicts: When evaluating mutually exclusive projects, the NPV and IRR methods can sometimes give conflicting rankings. The CFA study session covers “Ranking Conflicts between NPV and IRR” and “The Multiple IRR Problem and the No IRR Problem” . In such cases, NPV is generally preferred because it consistently selects the wealth-maximising alternative.

 

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