Course Progress
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The Moment of Decision: Capital Budgeting (NPV vs. IRR)
Chapter 5. The Moment of Decision: Capital Budgeting (NPV vs. IRR)
Should a company build a new semiconductor factory that costs 200 million blockbuster? These are the high-stakes decisions of Capital Budgeting.
Today, we will learn how to transition from “hope” to “logic” by using mathematical tools to determine if a project will actually create value for shareholders.
1. NPV: The Gold Standard
Net Present Value (NPV) is the cornerstone of corporate finance. it is calculated as: ==NPV = (Present Value of Future Cash Inflows) - (Initial Investment)==
- NPV > 0: The project creates value. ==Accept!==
- NPV < 0: The project destroys value. ==Reject!==
Why NPV is the Best
| Feature | Benefit | Why it matters |
|---|---|---|
| Time Value of Money | Reflected | Considers the cost of capital correctly |
| Cash Flow Focus | Reflected | Accounting profits are ignored for 'real' cash |
| Additivity | Possible | Total NPV = NPV(A) + NPV(B) |
2. IRR: The Rate of Intuition
Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project exactly zero. It represents the “break-even” rate of a project.
Know your required rate of return (k)
Solve for the rate where PV(Inflow) = PV(Outflow)
Is IRR > k? (Return > Cost)
If Return is higher than Cost, Accept!
==The Clash of Titans==: Most of the time, NPV and IRR agree. However, when projects have different scales or timing, NPV is always the superior choice because it measures the absolute wealth created, not just a percentage.
3. Alternative Tools: Payback Period & PI
Sometimes, managers use simpler tools for a quick check.
Supplementary Decision Tools
| Method | Core Question | Pros/Cons |
|---|---|---|
| Payback Period | How fast do I get my money back? | Simple but ignores TVM and late cash flows |
| Profitability Index (PI) | How much value per $1 invested? | Great for selecting under budget constraints |
4. Conclusion: Wealth Creation in Action
Capital budgeting is not just about crunching numbers. It’s about ==“Strategic Resource Allocation.”== A company that consistently accepts (+) NPV projects will see its stock price soar as it builds a future of sustainable cash flows.
📚 Prof. Sean’s Selected Library
- [Principles of Corporate Finance] - Brealey, Myers, Allen: The “Bible” of corporate finance used in every top-tier MBA program.
- [A Random Walk Down Wall Street] - Burton Malkiel: Context on why long-term corporate growth driven by smart budgeting matters to investors.
- [Execution] - Larry Bossidy: A look at the bridge between financial planning and real-world implementation.
Next time, we will explore the ‘Cost of Capital (WACC)‘—the hurdle rate that every project must jump over.