BFB1001 Chap.4 Risk and Capital Budgeting
Risk and Capital Budgeting
Risk and Capital Budgeting turns project proposals into dated incremental cash flows and evaluates them with net present value. Relevant cash occurs because the project is accepted, so past sunk costs are excluded while opportunity costs, changes in working capital, operating effects and terminal proceeds are included at their actual dates.
NPV discounts every signed cash flow at a return appropriate to project risk and measures expected value created at time zero. Internal rate of return expresses the break-even discount rate, while WACC can be suitable only when project risk resembles the firm's existing operations. Sensitivity and scenario analysis reveal which assumptions drive the decision.
A positive NPV is interpreted as value added after providing the required return, not as nominal future profit or a guaranteed outcome.
What this chapter covers
- 01
Incremental project cash flows
- 02
Sunk and opportunity costs
- 03
Net present value
- 04
Internal rate of return
- 05
Weighted average cost of capital
- 06
Sensitivity and scenario analysis
Worked example · free
Compute and interpret a project NPV
- 1Record the $90,000 cost at time zero as negative.
- 3Discount each inflow at 9% for its date.
- 2Add present inflows of $106,069.82 and subtract initial cost.
- 2Accept and interpret the $16,069.82 positive NPV as value added today.
Key terms
- Incremental cash flow
- Cash that changes because the project is accepted.
- Sunk cost
- A past cost that cannot be changed by the current decision.
- Opportunity cost
- The value of the best alternative benefit forgone.
- Net present value
- The time-zero sum of discounted signed project cash flows.
Risk and Capital Budgeting FAQ
Why use cash flow instead of accounting profit?
Investment decisions depend on actual funds committed and received at specific dates. Accounting profit can include non-cash allocations and omit the timing of investment, so it may not represent the cash resources changed by acceptance.
What does zero NPV mean?
Expected project cash flows exactly provide the risk-appropriate required return, with no extra value added at time zero. It does not mean the project produces no cash or no accounting profit.
When is WACC suitable?
It can be suitable when project risk resembles the firm's existing operations and financing risk is not materially changed. A project with very different operating exposure needs a rate reflecting that project rather than an automatic company average.
Why is a feasibility study often excluded?
If the study was paid before the current decision and cannot be recovered, it is a sunk cost. The project choice cannot change it, so including it would distort incremental value.
How is working capital treated in NPV?
Additional working capital is usually an initial outflow when committed and a later inflow when released. Its timing matters, and the recovery should appear only if the project actually makes those funds available again.
What does sensitivity analysis show?
It changes one assumption at a time to show how strongly NPV responds. It does not assign probabilities, but it identifies the variables that deserve better evidence, conservative assumptions or managerial protection.
Why should financing interest usually stay out of project cash flow?
The required return already represents the opportunity cost of the debt and equity financing used to support the project. Subtracting interest inside operating project cash and then discounting at that financing rate can count financing cost twice unless the method is explicitly designed otherwise.
How does IRR differ from NPV?
IRR expresses the discount rate at which project NPV equals zero, while NPV expresses dollar value created at a chosen required return. The measures can rank mutually exclusive projects differently when scale or timing differs, so NPV gives the more direct value comparison.
What makes a terminal cash flow relevant?
Disposal proceeds, cleanup cost or working-capital recovery belongs at the final project date when it occurs because acceptance causes it. The amount should be included once, signed correctly and discounted from that date. Omitting or double counting it can materially reverse the recommendation.
Assessment move
Create a dated audit of initial investment, installation, operating effects, working capital, opportunity costs and terminal cash flows before using Excel. Write a causal label beside each amount and ask whether it changes between accepting and rejecting the project. Exclude sunk costs, keep outflows negative and prevent terminal recovery from appearing twice.
Compute present value by date, sum signed values and finish with a sentence linking the NPV sign to value created after the required return. Compare NPV and IRR as different decision forms rather than interchangeable numbers. Use WACC only after checking project risk is comparable to the firm's existing assets.
Rework one example with lower operating cash, a delayed inflow and a higher hurdle, predicting each direction before calculation. For every sensitivity result, name the practical response, such as gathering demand evidence, staging investment or protecting resale value. The spreadsheet should reveal a transparent model, not hide cash-flow classification inside unexplained net cells.
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