Chapters 12 & 13 · Van Horne, 13th Ed.

Capital Budgeting

Quick MBA study notes — read in 12 minutes

Part A · Chapter 12 — Estimating Cash Flows

1The Big Idea

Capital budgeting is how a firm decides which long-lived investments (equipment, new products, plants) are worth undertaking. Every decision starts the same way: forecast the right cash flows, then judge whether they clear the required return.

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Key Concept Only cash, not accounting income, matters. Cash is what gets reinvested or paid to shareholders — profit on paper doesn't pay anyone.

Analogy: you can't pay rent with "net income" on a spreadsheet — you pay it with cash in the bank. Same logic applies to evaluating a project.

2The Cash-Flow Checklist

Relevant project cash flows must be:

Cash flows, not accounting income
Operating flows, not financing flows (interest/dividends are excluded — the discount rate already captures financing cost)
After-tax
Incremental — the difference the project makes, with vs. without it

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Key Concept Ignore sunk costs (money already spent — irrelevant to future decisions). Always include opportunity costs (what you give up by using an asset for this project instead of something else).

3Three Buckets of Project Cash Flow

Stage	What it captures
Initial outflow	Cost of new asset(s) + installation − sale of old asset (net of tax) ± working capital change
Interim cash flows	Change in operating revenue − change in costs − change in taxes, plus depreciation added back
Terminal cash flow	Last year's operating flow + after-tax salvage value + working capital recovery

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Key Concept Depreciation isn't a cash flow itself, but it lowers taxes — so it's subtracted to find taxable income, then added back to get the actual cash flow. Faster depreciation → lower near-term taxes → better cash flow sooner.

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Also Remember Extra working capital (inventory, receivables) needed for a project is a cash outflow when invested and a cash inflow when recovered at the project's end. Don't forget to factor in expected inflation too.

Part B · Chapter 13 — Evaluation Techniques

4Payback Period — Quick but Flawed

How many years to recover the initial investment from expected cash flows.

Example

$100,000 outlay; cash flows of $34,432 / $39,530 / $39,359 / $32,219 → payback ≈ 2.66 years.

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Key Concept Simple and popular, but it ignores the time value of money and any cash flows after the cutoff — it measures liquidity, not profitability.

5Net Present Value (NPV)

NPV = Σ CFₜ/(1+k)ᵗ − ICO

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Key Concept Accept if NPV ≥ 0. NPV tells you the exact dollar amount added to shareholder wealth — the gold-standard metric because it's expressed in real money, not a ratio or rate.

6Internal Rate of Return (IRR)

The discount rate that makes NPV exactly zero — i.e., the project's own "break-even" rate of return.

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Key Concept Accept if IRR ≥ required rate (hurdle rate). For a single conventional project, IRR and NPV always agree on accept/reject.

7Profitability Index (PI)

PI = PV of future cash flows / ICO

Example

$110,768 PV of inflows ÷ $100,000 initial outflow = PI = 1.11

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Key Concept Accept if PI ≥ 1.00. Useful for ranking projects per rupee/dollar invested — handy under capital rationing when funds are limited.

8When Rankings Conflict

For mutually exclusive projects, IRR, NPV, and PI can disagree on which is "best" — due to differences in:

Scale of investment
Cash-flow pattern (timing)
Project life

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Key Concept When methods disagree, always follow NPV — it picks the project that adds the most absolute dollar value to the firm.

9Cheat-Sheet: Accept/Reject Rules

Method	Formula	Accept if
Payback	Years to recover ICO	≤ target cutoff
NPV	ΣCF/(1+k)ᵗ − ICO	NPV ≥ 0
IRR	Rate where NPV = 0	IRR ≥ required rate
PI	PV(CF)/ICO	PI ≥ 1.00

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Capital budgeting is a two-step discipline: forecast honest, incremental after-tax cash flows, then let NPV — not gut feel — decide whether the project truly creates value.