Uncertainty in Capital Budgeting: Five Particular Safety-(or Danger-) Margins from the NPV Formula

Abstract

The primary approaches for evaluating prospective capital projects, which are investments (outlays) with future financial benefits, are net present value (NPV) and the internal rate of return (IRR), both based on the discounted expected positive and negative cash flows. The NPV formula can be used to provide three additional insights into the evaluation of prospective investment opportunities: normal profit, economic (discounted) payback (or breakeven) period, and maximum investment cost.

A review of over two centuries of discussion of capital budgeting techniques reveals no discussion of two alternative approaches and little discussion of a third. This note explores the evolution of capital budgeting techniques, and explains with examples these variations of the NPV formula as additional approaches to evaluating inherently uncertain investment decisions. The formula can be used to calculate “safety-margins” (also “danger-margins”) in evaluating potential investments.