FINM1001 Chap.5 Making Investment Decisions
Making Investment Decisions
Build the counterfactual before discounting
Capital budgeting compares the firm with a project against the firm without it. Relevant cash flows are incremental: they change because the project is accepted. This definition includes new operating cash, capital expenditure, working-capital commitments, disposal proceeds, opportunity costs and side effects on existing business.
It excludes payments that are already irreversible.
A sunk cost cannot be changed by the decision and should not enter NPV. An owned asset can still carry an opportunity cost when project use sacrifices rent, sale proceeds or another feasible benefit.
The absence of a new invoice does not make a resource free; the correct question is what accepting the project causes the firm to give up.
Depreciation is not a cash outflow, but it can lower taxable income and create a tax shield. Build operating cash flow from cash revenues, cash expenses and tax effects, then place capital expenditure and working capital on their actual dates.
Terminal cash flow may include operating cash, working-capital recovery and after-tax disposal value.
Let NPV produce the decision
Discount every incremental future cash flow at the appropriate required return and subtract the initial investment. Positive NPV indicates estimated value creation and supports acceptance; negative NPV indicates the project fails to meet the required return and supports rejection.
Zero leaves the firm indifferent under the stated assumptions.
Mutually exclusive projects require care because accepting one prevents accepting another. When lives differ and replacement assumptions make annual comparison relevant, equivalent annual value can restate each NPV on a comparable annual basis.
Do not use that adjustment automatically for independent projects or when the economic setting does not support replacement.
A strong answer prints the incremental boundary, cash-flow dates, discount rate and decision. Sensitivity analysis changes one uncertain input transparently and recomputes the consequence.
It should diagnose which forecast drives value, not manipulate assumptions until the preferred project becomes positive.
What this chapter covers
- 01
Incremental cash flow
- 02
Sunk and opportunity costs
- 03
Tax effects
- 04
Net present value
- 05
Equivalent annual value
Worked example · free
Evaluate an automation line
- 1Value the annual savings as an ordinary annuity.
- 1Discount the resale amount from year four.
- 1Subtract the initial investment.
- 1State the conditional decision.
Key terms
- Sunk cost
- A past or committed cost that cannot be changed by accepting or rejecting the project and is therefore excluded from incremental analysis.
- Opportunity cost
- The value of the best feasible alternative sacrificed when a resource is committed to the proposed project.
- Depreciation tax shield
- The tax saving created when depreciation reduces taxable income, despite depreciation itself not being a cash payment.
- Equivalent annual value
- An annualised expression of NPV used under appropriate assumptions to compare mutually exclusive alternatives with unequal lives.
Making Investment Decisions FAQ
Why is a feasibility study often excluded?
When its payment is already irreversible, accepting or rejecting the project cannot change it. It is sunk and does not belong in the incremental comparison.
Why can an owned building have a project cost?
Using it can sacrifice rent, sale proceeds or another opportunity. That forgone benefit is caused by acceptance and therefore enters as an opportunity cost in the incremental cash-flow forecast.
Does depreciation reduce cash directly?
No. It is a non-cash accounting charge, but when tax is relevant it can reduce taxable income and create a real depreciation tax shield for the project.
What does a negative NPV mean?
Discounted incremental benefits fall short of incremental costs at the required return. Reject under those forecasts unless an external constraint changes the decision problem or the underlying estimates require revision.
Exam move
For every project item, write accept cash flow minus reject cash flow and assign a date. Only then calculate tax, discounting and the final NPV recommendation. Use separate rows for revenue, cash expense, tax, depreciation shield, capital expenditure, working capital and disposal. This layout lets you change one forecast without disturbing unrelated amounts.
Reconcile the final year independently because it often contains ordinary operations plus asset sale and working-capital recovery. After computing NPV, identify the assumption with the greatest plausible effect and test it within a stated range. If two mutually exclusive projects both have positive NPVs, compare value under consistent horizons and constraints.
If both are negative but an external rule requires one, the problem changes from value creation to least value destruction. State whether the project is optional or compulsory, because that condition controls the closing recommendation and may require an equivalent-annual comparison.
Audit the project table vertically as well as horizontally: each year should contain every relevant category, and each category should reconcile over the full horizon. This cross-check catches stranded working capital, missing disposal tax and benefits accidentally counted twice.
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