What it calculates

Capital budgeting evaluates whether a long-lived investment is worth making, using net present value, internal rate of return, payback period and profitability index side by side. It is the discipline that stops capital being allocated on enthusiasm.

How it is calculated

Project the incremental after-tax cash flows the investment causes - only the cash flows that change because of the decision. NPV discounts them at the cost of capital and sums them; positive means the project adds value. IRR is the discount rate at which NPV is zero. Payback counts how long until cumulative cash flow turns positive. Profitability index is present value of inflows divided by the initial outlay, which is useful when capital is rationed.

How to read the result

NPV is the decision rule; the others are context. IRR is intuitive but breaks down when cash flows change sign more than once and it silently assumes reinvestment at the IRR itself, which is usually optimistic. Payback ignores everything after the cut-off and the time value of money entirely, so treat it as a liquidity check rather than a profitability measure. When NPV and IRR disagree on ranking mutually exclusive projects, follow NPV.

Worked example

An outlay of 500,000 returns 150,000 a year for five years at a 10% cost of capital. The present value of the inflows is about 568,600, so NPV is 68,600 and the project is accepted. IRR is roughly 15.2%, payback is 3.3 years, and the profitability index is 1.14.

Common questions

Should sunk costs be included?

Never. Money already spent cannot be recovered by any decision you make now, so it is irrelevant to whether to proceed. Including it is the single most common way good projects get rejected and bad ones get continued.

What discount rate should I use?

The cost of capital appropriate to the project's risk, not necessarily the company's overall WACC. A project riskier than the existing business should be discounted at a higher rate; using a single corporate rate for everything systematically over-invests in risky projects and under-invests in safe ones.

Why can IRR give a misleading answer?

Cash flows that alternate sign can produce multiple IRRs or none at all, and IRR assumes interim cash is reinvested at the IRR rather than at the cost of capital. It also ignores scale: a small project with a high IRR can add less value than a large project with a lower one.