Capital Budgeting: NPV, IRR and Payback
Capital budgeting is the process of evaluating and selecting long-term investment projects that maximize shareholder value. In interviews, the important question is not just whether a project has a strong return, but whether it creates value after considering the cost of capital, timing of cash flows and project scale.
- Capital budgeting is the process of evaluating and selecting long-term investment projects that maximize shareholder value.
- NPV (Net Present Value) is theoretically correct because it accounts for TVM and scale.
- IRR (Internal Rate of Return) is intuitive as % return and easy to communicate to management, but multiple IRRs are possible.
- MIRR (Modified IRR) fixes IRR's reinvestment assumption flaw.
- Payback Period is simple and good for liquidity-constrained firms, but ignores TVM and cash flows after payback.
- When NPV and IRR conflict for mutually exclusive projects, always choose by NPV.
Capital Budgeting Big Picture
Finance managers use multiple decision metrics to evaluate long-term investment projects. NPV, IRR, MIRR, Payback Period, Discounted Payback and Profitability Index each answer a different question, but the golden rule is that NPV measures value creation in absolute terms.
NPV vs IRR Conflict
When NPV and IRR give different rankings for mutually exclusive projects, always prefer NPV. IRR can be misleading when:
NPV measures value creation in absolute terms - always superior for investment decisions.
Capital Budgeting Example - Indian Solar Project
This example applies the capital budgeting toolkit to an Indian solar project. The project is evaluated at a 12% WACC, with cash flows, present values and decision metrics shown below.
The decision is clear on value creation: NPV is +332.5 Cr, so the project is accepted at 12% WACC. IRR is ~22.4%, well above 12% WACC, while payback is ~5.5 years, reasonable for infrastructure.
NPV vs IRR Worked Drill
A company has โน1,000 Cr to deploy and must choose between two mutually exclusive projects. WACC = 10%. Which project creates more value?
Resolution: Project A's high IRR of 24% comes from early cash flows (front-loaded). Project B pays more in total but later. At WACC = 10% discount rate, Project B's larger total cash flows generate โน560 Cr NPV vs only โน125 Cr for A.
Rule: When NPV and IRR conflict for mutually exclusive projects, always choose by NPV. IRR assumes reinvestment at IRR itself (unrealistic); NPV assumes reinvestment at WACC (correct). Payback: Project A paybacks in ~2 years; Project B in ~3.5 years. For a cash-constrained company, payback matters despite NPV superiority of B.
Structuring a Capital Budgeting Interview Answer
"A company has โน1,000 Cr to deploy and must choose between two mutually exclusive projects. WACC = 10%. Which project creates more value?"
Do not let a higher IRR or faster payback override NPV on mutually exclusive projects. IRR can be misleading when projects have different scales, different lives or unconventional cash flows.
The most frequent error is choosing the project with the higher IRR when NPV and IRR conflict. This costs points because IRR can ignore project scale and be biased toward short-term cash flows, while NPV measures value creation in absolute terms.
Conclusion
Capital budgeting is a value-creation decision toolkit: use multiple metrics, understand their strengths and weaknesses, and use NPV as the final tie-breaker when IRR or payback give tempting but misleading signals.