Lesson 68 - Intermediate Accounting Course 

68. Capital Budgeting: Payback Period, NPV, and IRR Explained

Capital budgeting is the decision-making process that businesses use to evaluate potential long-term investments, such as purchasing new equipment, expanding operations, or launching a new product. Companies use different financial metrics to determine whether an investment is worth pursuing. Three of the most common methods are:

• Payback Period
  
  

• Net Present Value (NPV)
  
  

• Internal Rate of Return (IRR)
  
  

Each method provides insight into the profitability and risk of a potential investment.

1️⃣ What is Capital Budgeting?

Capital budgeting is the process of analyzing and selecting long-term investments that will generate future cash flows. It helps businesses decide:

✅ Which projects to invest in.
✅ How to allocate resources effectively.
✅ Whether an investment will be profitable over time.

2️⃣ Payback Period Method

🔹 Definition:
The Payback Period calculates how long it takes for an investment to recover its initial cost through cash inflows.

🔹 Formula:

🔹 Example:

A company invests $100,000 in a new machine that generates $25,000 per year in cash inflows. 

🔹 Pros:
✔️ Simple to calculate and understand.
✔️ Helps assess investment risk (shorter payback = lower risk).

🔹 Cons:
❌ Ignores cash flows after the payback period.
❌ Doesn't account for the time value of money (TVM).

3️⃣ Net Present Value (NPV) Method

🔹 Definition:
NPV calculates the present value of future cash flows, adjusting for the time value of money. It shows whether an investment will add or subtract value from the company.

🔹 Formula:

🔹 Example:

A company invests $50,000, expecting cash flows of $20,000 per year for 3 years, with a discount rate of 10%. 

If NPV > 0, the investment is profitable.
If NPV < 0, the investment should be rejected.

🔹 Pros:
✔️ Considers the time value of money.
✔️ Helps determine if an investment increases company value.

🔹 Cons:
❌ Requires an estimated discount rate, which can be subjective.
❌ More complex than the Payback Period method.

4️⃣ Internal Rate of Return (IRR) Method

🔹 Definition:
IRR is the discount rate that makes NPV = 0. It represents the annualized return an investment is expected to generate.

🔹 Formula:
IRR is found by solving:

This requires trial-and-error or financial calculators.

🔹 Example:
If an investment of $10,000 generates $4,000 per year for 3 years, the IRR might be 15% (calculated using financial software).

🔹 Decision Rule:
✔️ Accept if IRR > Required Rate of Return.
✔️ Reject if IRR < Required Rate of Return.

🔹 Pros:
✔️ Considers the time value of money.
✔️ Provides a percentage return, making comparisons easier.

🔹 Cons:
❌ Can be difficult to calculate without financial software.
❌ May give misleading results for projects with non-standard cash flows.

5️⃣ Comparing the Three Methods 

6️⃣ Final Thoughts

🔹 Use Payback Period when you need a quick risk assessment.
🔹 Use NPV for the most accurate profitability analysis.
🔹 Use IRR when comparing projects with different investment sizes.