Capital Budgeting for Indian SMEs — When to Use Payback Period vs NPV vs IRR

The three tools every business owner should know

Payback Period: How long to recover your investment. Simple to calculate and understand. Good for liquidity-constrained businesses — you need to know when you'll get your money back.

NPV (Net Present Value): The present value of all future cash flows minus the investment. Positive NPV = investment adds value above required return. Best for comparing projects of different sizes.

IRR (Internal Rate of Return): The discount rate at which NPV = 0. Essentially the investment's 'internal' return rate. Compare to cost of capital: if IRR > cost of capital, proceed.

Which to use when

| Situation | Best Metric | |---|---| | Quick equipment decision | Simple payback | | Choose between two machines | NPV | | Multiple projects, limited capital | IRR | | Bank loan application | NPV + payback |

Common mistake: focusing only on payback

A machine with 2-year payback that lasts 5 years is less valuable than a machine with 3-year payback that lasts 15 years. Payback alone ignores the profitable years beyond recovery. Always calculate total NPV for significant investments.