Corporate Finance: Capital Budgeting

Imagine you are the CEO of Tata Motors. You have ₹1000 Crores. Should you: A) Build a new EV factory? B) Acquire a smaller company? C) Put it in the bank?

Capital Budgeting is the science of making this decision.

The Time Value of Money (Refresher)

₹100 today is worth MORE than ₹100 next year. Why? Because you can invest it and earn interest. So, future cash flows must be discounted to today's value to compare them.

1. Net Present Value (NPV) - The Gold Standard

NPV = (Present Value of Cash Inflows) - (Initial Investment)

• Rule:
  • If NPV > 0: Accept the project. (It adds value).
  • If NPV less than 0: Reject the project. (It destroys value).

Example:

• Investment: ₹100.
• Returns: ₹50 next year, ₹70 year after.
• Discount Rate: 10%.
• PV of ₹50 = 50/1.1 = 45.45
• PV of ₹70 = 70/1.21 = 57.85
• Total PV = 103.3
• NPV = 103.3 - 100 = +3.3 (Accept!)

2. Internal Rate of Return (IRR)

IRR is the "interest rate" the project generates. It is the discount rate at which NPV becomes Zero.

• Rule:
  • If IRR > Cost of Capital (WACC): Accept.
  • If IRR less than Cost of Capital: Reject.

Example: If a project gives 15% return (IRR) and you borrowed money at 10% (Cost), you make 5% profit.

3. Payback Period

How much time to recover the initial money?

• Example: Invest ₹100. Get ₹50/year.
• Payback: 2 years.
• Flaw: It ignores time value of money and profits after payback. But small business owners love it for simplicity.

Weighted Average Cost of Capital (WACC)

This is the "Hurdle Rate." It is the average cost of the company's funds (Equity + Debt). A project MUST earn more than WACC to be viable.

7-Day Action Plan

Day 1: Understand the concept of "Discounting" (Reverse of Compounding).
Day 2: Use Excel to calculate NPV. Formula: =NPV(rate, value1, value2...).
Day 3: Use Excel to calculate IRR. Formula: =IRR(values).
Day 4: Apply this to your life: Should you do an MBA?

• Cost: ₹20 Lakhs.
• Extra Salary: ₹5 Lakhs/year.
• Calculate NPV over 10 years.
  Day 5: Read about a company's "Capex" (Capital Expenditure) plan in news.
  Day 6: Understand why high interest rates reduce NPV (and thus reduce business investment).
  Day 7: Teach the concept of "Opportunity Cost" to a friend.

Quiz

💡 Final Wisdom: In business and life, always ask: "Is the return worth the cost?" That is Capital Budgeting.