Business Knowledge

Capital Budgeting Rules

How to Decide if a Project is Worth It

Use these three financial tests to evaluate a major investment.

1. Net Present Value (NPV)

  • Question: In today’s money, how much value will this project create?
  • The Rule: If NPV is positive, it’s a go. If it’s negative, walk away.
  • Why it’s great: It’s the most reliable rule for making a decision.

2. Internal Rate of Return (IRR)

  • Question: What is the percentage return on this investment?
  • The Rule: If the IRR is higher than your company’s “hurdle rate” (your cost of capital), it’s a go.
  • Why it’s popular: It’s easy to understand and communicate.

3. Payback Period

  • Question: How fast will I get my money back?
  • The Rule: If it’s faster than your company’s cutoff (e.g., 3 years), it’s a go.
  • Why it’s used: It’s a simple, quick gut-check for risk.

The Golden Rule: Always use NPV as your primary decision-making tool, especially when comparing different projects. Use IRR and Payback Period for additional context and as quick screening tools.