FIN Lesson 3: Capital Budgeting and Investment Decisions
Capital Budgeting – is the process of evaluating and selecting long-term investments that align
with a company's strategic objectives. It involves determining whether potential investment
projects are worth pursuing based on their expected returns and associated risks.
Capital Budgeting Techniques – these techniques help assess the financial viability of
investment projects:
● Net Present Value (NPV) – measures the difference between the present value of cash
inflows and outflows, determining the added value of a project.
● Internal Rate of Return (IRR) – identifies the discount rate at which the project's net
present value equals zero, representing its expected rate of return.
● Payback Period (PBP) – calculates the time required to recover the initial investment
from the project's cash flows.
● Profitability Index (PI) – compares the present value of future cash flows to the initial
investment as a ratio to evaluate project profitability.
Risk Analysis in Investment Decision – risk analysis helps evaluate uncertainties in cash flows
and their impact on project viability.
● Sensitivity Analysis – examines how changes in a single variable (e.g., revenue, costs,
discount rate) affect the NPV or IRR.
● Scenario Analysis – evaluates the project under different scenarios (e.g., best case, worst
case, most likely case) to assess variability in outcomes.
● Monte Carlo Simulation – uses statistical methods to simulate a range of possible
outcomes for uncertain variables, providing a probability distribution of NPV or IRR.
● Adjusted Discount Rate – incorporates risk by using a higher discount rate for riskier
projects.
● Real Options Analysis – considers the value of flexibility in decision-making, such as
delaying, expanding, or abandoning a project.
Making Informed Investment Decisions:
● Evaluate Cash Flows – ensure cash flow projections are realistic and based on accurate
data.
● Choose the Right Technique – use NPV or IRR for detailed evaluations and supplement
with simpler methods like PBP for additional insights.
● Incorporate Risk Analysis – analyze potential risks and their impacts using sensitivity,
scenario, or simulation techniques.
● Prioritize Strategic Fit – ensure the investment aligns with the company’s long-term
strategic goals.
● Consider Non-Financial Factors – assess environmental, social, and regulatory
implications of the investment.
