Capital budgeting and risk analysis

Capital budgeting decides which long-term projects to fund: a new plant, a product line, a machine. Because the money is large and locked in for years, the decision must compare cash flows over time, not just profits in one year. The tools are payback period, accounting rate of return, net present value (NPV) and internal rate of return (IRR), plus the profitability index. Worked example: a project costs 100,000 and returns 60,000 after one year and 60,000 after two years, at a 10% discount rate. Present value = 60,000/1.10 + 60,000/1.21 = 54,545 + 49,587 = 104,132, so NPV = 104,132 - 100,000 = +4,132: the project adds value and should be accepted.