This lesson examines the techniques used to evaluate long-term investment projects.

4.1 The Capital Budgeting Process

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximising shareholder value . The core principle is that a project should be accepted if it creates value—if its expected return exceeds its required return.

4.2 Key Evaluation Techniques

  • Net Present Value (NPV): The difference between the present value of cash inflows and outflows . This is the most theoretically sound criterion—a positive NPV indicates value creation.

  • Internal Rate of Return (IRR): The discount rate that makes NPV equal to zero . A project is accepted if IRR exceeds the cost of capital.

  • Payback Period: The time required to recover the initial investment . This is a simple but flawed measure that ignores the time value of money and cash flows beyond the payback period.

  • Profitability Index: The ratio of the present value of future cash flows to the initial investment.

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